Narang, Inside the Black Box, 2d ed.

I never read the first edition of Rishi K. Narang’s Inside the Black Box: A Simple Guide to Quantitative and High-Frequency Trading, so I was delighted when Wiley published a second edition this year and I finally got the chance to find out what’s really “inside the black box.” It turns out that it’s not something mysterious but rather something that every trader should aspire to, whether his eventual trading box is black or translucent. In brief, this book is not just for those who want to know what quants do (though it does an excellent job of describing their role in the investment community) but for everyone whose trading is informed by more than dart throwing or gut reactions.

At its most basic, a quant trading strategy consists of an alpha model, a risk model, and a transaction cost model, all of which “feed into a portfolio construction model, which in turn interacts with the execution model.” (p. 17) Necessary to build and run these models are data and research.

Let’s assume that you are a retail trader. To make things really simple, I’m going to further assume that you don’t have to worry about portfolio construction but rather are using a small portion of your overall portfolio to trade a single instrument. First, you need a model, either testable (if a hypothesis) or adaptive (if the result of data mining), of when to buy and when to sell that will give you an edge. Second, you need to set up some rules that will improve the quality and consistency of your returns and that will prevent you from losing your shirt. Third, you have to figure out what broker to use and on what time frame to trade so that transaction costs don’t swamp potential profits. And finally, you have to figure out how to execute your trades—what kind of an order to use, whether it is automatically generated based on an algorithm or entered by hand, whether to scale in and out, etc.

In brief, at least in outline every retail trader, even the discretionary trader, should do what the quants do. For starters, focused, scientifically driven research. Narang’s book provides something of a road map that everyone can use. The non-quant retail trader won’t go as far as the professional quant; to analogize, faced with a map of the U.S. he might decide to start in Connecticut and end in Pennsylvania whereas the quant might go from Connecticut to Nevada (I couldn’t resist the Las Vegas image). Without the road map, however, he might end up drowning in the ocean or speeding down to Florida only to be swallowed up by a sink hole.

Narang divides his book into four parts: the quant universe, inside the black box, a practical guide for investors in quantitative strategies, and (new to this edition) high-speed and high-frequency trading. The text is highly readable. No math is required, only, I would suggest, an interest in scientific inquiry and a curiosity about the world that the mathematical elite inhabit. Inside the Black Box is an enlightening and potentially enriching read.