Inside the Black Box

The subtitle of Inside the Black Box is "A Simple Guide to Quantitative and High-Frequeny Trading", which means it is of interest to algorithmic sports traders. Starting with quantitative methods in algorithmic trading, the book discusses the importance of the mathematical understanding of markets rather than blind data mining methods.

The difference between the two is subtle but important as data mining can discover short term anomalies that are unprofitable when used as indicators for trading. A model should be theory driven. In other words prove why something happens and then model it rather than observing without understanding as is sometimes the case in data mining.

Following chapters discuss a modular approach to building a black box trading system. The black box is split into an alpha model (the money making strategy), a risk model (to control drawdowns) and a transaction model (to execute the trade as cheaply as possible). Finally, there is the portfolio construction model which uses the previous three models to build a portfolio of trades that will make as much money with the least amount of risk and with the optimal amount of capital. The book continues with execution algorithms, the importance of data and its usage in model building, researching trading strategies and evaluating strategies.

For sports traders who are new to algorithmic trading this book makes for a good framework with which to base a black box trading application. In terms that a sports trader would understand the alpha model is created by looking at data and generating hypotheses for its behaviour. The risk model is for creating stops and limits to handle unforeseen circumstances. The transaction model for sports trading would involve looking for the best prices, factoring in commission and bonuses and/or the use of synthetic bets to mimic the required bet but at a superior price or lower cost. Finally, the portfolio construction model takes all three models to build a portfolio of trades for a day's trading to optimise return on investment.

The book also covers evaluating quantitative methods and high-frequency trading. Although high-frequency trading is not really possible in sports trading (see Programming for Betfair: A Guide to Creating Sports Trading Applications with API-NG), you can think of it as low-latency trading and the optimisation of your hardware and software to be as fast as it can for the job at hand. This book is a very good introduction to algorithmic trading.

See also