Book: The Predictors. By T.A.Bass.

The Predictors : How a Band of Maverick Physicists Used Chaos Theory to Trade Their Way to a Fortune on Wall Street. T.A.Bass

This is a non-fiction book. The physicists are chaos theorists Doyne Farmer and Norman Packard — but this is not a chaos text. In fact, there is little technical information in the book. It’s more about the business side of starting a financial prediction company. To quote: “They begin an animated discussion about some of the basic ideas that will later be used at Prediction Company. The technique involves fitting functions to time series. Imagine a stream of data, a record of daily sunspot activity, for example. The sunspot activity on two successive days is two numbers, which can be represented as points in a plane. The sunspot activity on the next day can be thought of as a point suspended above this plane. The picture of sunspot activity for a year will be a cloud of points in three dimensional space. To make a forecasting model, one fits a surface, like a rumpled sheet, through this cloud of data. If the sheet fits in close proximity to all the data points, it will be a good model. Forecasts are made by stretching the sheet into regions where additional data points will be recorded when the future rolls into the present”. The idea is in the air… This description is recognisable to someone who has independently arrived at something similar — but probably not informative to the rest. What you want to do is data compression of some sort, and there are more conservative compression tools than a fit. One may¬† object to the business model of striking an exclusive deal with a single large client, as opposed to marketing the service to thousands of individual traders. Overall, valuable historic reading to someone with similar interests.

Book: The Crowd. G. le Bon

The Crowd. G. le Bon

A book whose relevance seems to only grow with time since its first publication in 1898. Le Bon’s “crowd” is in most examples a group of people at the same physical location, seeing and hearing each other immediately, and responding to the stimuli they immediately observe. These days there emerges a global crowd interconnected by modern means of communication unheard of in le Bon’s age. As both the crowd and its scope of attention are thus expanded, the basic dynamics likely remains the same, as does the human nature. The relevance of the book grows with the crowd phenomenon it describes — that is, in proportion to the growth of the mass media and means of communication.

Here at where our business is to turn mood swings of the financial market crowd into profit opportunities, we cannot but add this book to our bookshelf (if not keep it on our desktop, as did Lenin according to some sources). What le Bon does using the methodology of the social siences, we do using that of the precise sciences. He describes, we measure. If you think markets become more fficient as their liquidity grows, think again or read le Bon: a larger crowd is still a crowd. And a crowd is driven by its own dynamics, and is less rational — and possibly is easier to predict and control — than any of its individul members, no matter who they are. This applies to a crowd of nineteenth century’s leading scientists in one of le Bon’s anecdotes as it may apply to a crowd of Wall Street CEOs in what created the subprime crisis episode of 2007-200?.

Book: Fooled by Randomness. By N.N.Taleb.

Fooled by Randomness. The Hidden Role of Chance in Life and in the Markets. N.N.Taleb

A thought-provoking reading. The author definitely enjoys and thrives on expressing a number of well articulated sharp opinions on a number of subjects.

Among other things, Taleb uses a trend-on-top-of-noise model to make the point that larger time scale improves what a natural scientist would call signal-to-noise ratio in the analysis of investment performance. The short time scale is mostly meaningless; the significance of performance record grows with time scale. To quote Taleb: “This explains why I prefer not to read the newspaper (outside the obituary), why I never chitchat about markets, and, when in a trading room, I frequent the matematicians and the secretaries, not the traders. It explains why it is better to read The Economist on Saturdays than the Wall Street Journal every morning (from the standpoint of frequency, aside from the massive gap in intellectual class between the two publications).”

Book: Dynamics of Markets by J.L.McCauley.

Dynamics of Markets. Econophysics and Finance. J.L.McCauley

Econophysics is, very roughly speaking, economics or econometrics done by physicists or done the way physicists — or natural scientists for that matter — would do it. In particular, the emphasis is on quantitative real-life evidence and natural-science-style methods of inference.

On the particular subject of correlations (the little specialty of this site), the author states (Section 3.7) that “liquid markets (stock, bond, foreign exchange) are very hard to beat, meaning that to a good zeroth approximation there are no long-time correlations that can be exploited for profit”. More specifically: “Financial data indicate that strong initial pair correlations die out relatively quickly on a time scale of 10min of trading”.

In our Currency Alpha section we compare this with our own observations.