I love stories. I love reading. I love writing. I’ve also spent a decade in financial markets, a period which I’ve thoroughly enjoyed, despite the turbulent times the market has been through during much of this time. Hence, it seemed natural to put together these interests to write a book about markets from a quantitative perspective. Hence I wrote Trading Thalesians – What the ancient world can teach us about Trading Today. The below excerpt is from a chapter entitled “The Silk Road and its Secrets: Is There Really a ‘Secret Sauce’ in Trading?” But first, a short introduction.
Indeed, I had a vague recollection of the name from the geometric theorem named after him. I knew little else until I read a biography of Thales entitled simply Thales of Miletus (O’Grady, 2002). So what did Thales of Miletus have to do with a twenty-first-century quantitative finance group? After all, Paul had named our group, the Thalesians, literally denoting us as the followers of Thales of Miletus.
On the surface, the relationship between our group and Thales of Miletus seems tenuous, until we note that Thales of Miletus was actually one of the first people to trade derivatives. You know derivatives, those mysterious financial contacts built by people we used to call financial engineers, with letters such as PhD after their names, and prefixes such as professor. Admittedly, Thales of Miletus did not create such exotic financial instruments with funny names, such as CDO^2, whose complexity and unwieldiness ensured that investors would never quite understand them.
I asked a more general question about whether Thales of Miletus could tell us something about modern financial markets
Instead, Thales of Miletus traded his derivatives on an underlying, which is still familiar to people who live around the Mediterranean today, namely olives or more precisely olive presses. He essentially bought options, which gave him the right (but not necessarily the obligation) to use olive presses at a pre-agreed price. In the Politics, Aristotle tells us the story of Thales and his olive presses:
Thales … when they reviled him for his poverty, as if the study of philosophy was useless: for they say that he, perceiving by his skill in astrology that there would be great plenty of olives that year, while it was yet winter, having got a little money, he gave earnest for all the oil works that were in Miletus and Chios, which he hired at a low price, there being no one to bid against him; but when the season came for making oil, many persons wanting them, he all at once let them upon what terms he pleased; and raising a large sum of money by that means, convinced them that it was easy for philosophers to be rich if they chose it, but that that was not what they aimed at; in this manner is Thales said to have shown his wisdom. (Aristotle & Ellis (trans), 1912)
Later, Aristotle notes that this is an example of a monopoly. The story told by Aristotle about Thales sparked a thought in my brain. My focus was not so much on the notion of a monopoly, something that could be construed as market manipulation in the current day or more specifically “cornering” the market.
In any case, there are many examples where such behavior resulted in ruin for the protagonists, such as the Hunt brothers’ attempt to corner the silver market in the 1970s. We could also argue that a sample of one trade is not sufficient to judge Thales’ trading prowess (see Chapter 9 on examination of historical data).
If your primary objective is purely to make money from trading quickly, you can make decisions that perversely increase the likelihood of losing
Instead, I asked a more general question about whether Thales of Miletus could tell us something about modern financial markets. Is the way to succeed as a trader not to think purely about making money and instead to have other goals (see Chapter 5)? After all, Thales of Miletus was not primarily a trader. Aristotle tells us he merely used his intellect to prove that he could make money. The rationale is that if your primary objective is purely to make money from trading quickly, you can make decisions that perversely increase the likelihood of losing.
In John Kay’s book Obliquity (Kay, 2011), he keeps with this theme, arguing that goals are best achieved indirectly. He cites happiness, amongst his examples. He notes that those who are happiest rarely pursue it as a goal; instead it is a by-product of their circumstances. Bertrand Russell echoes these sentiments in the Conquest of Happiness (Russell, 1999 (reissue)). Forever thinking about happiness is not a way to find it, Russell suggests. Telling a girl you are madly in love with her upon first meeting her is unlikely to result in the reciprocation of that sentiment!
Is There Really a ‘Secret Sauce’ in Trading?
So, if many strategies are similar, what precisely could constitute a “secret sauce?” We may conjecture that the differences between various funds are more in terms of the details of implementation, rather than the general strategies they employ; we suggest these are likely to be similar and account for the high level of correlations between funds. When all these subtle differences are added up, they can considerably improve the performance of the strategy.
This also includes the skills required to run and implement a trading strategy. It could also simply be a case of having sufficient knowledge gleaned over years about a particular market to be able to squeeze out the last few cents from a trading idea.
These barriers to entry could also constitute part of the “secret sauce.” At the very simplest level, a trader needs access to capital, another barrier to entry. Stating the blatantly obvious, without capital a trader is not going to be able to generate returns. Indeed, the same was true of silk. Even if at some level some of the Ancient Romans seemed to have a general idea of how to create silk, it would be futile without silkworms.
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Whilst there might be some appeal in a super-complicated black box trading strategy which has amazing returns, I for one would have difficulty running such a trading strategy with my own money.
When something is unobtainable or has some element of mystique around it, it suddenly becomes that bit more appealing.
Hence, the idea of some amazing “secret sauce” based upon a single secret in trading seems unlikely, and indeed this is the message from Narang (2009). Just because a strategy is complicated it does not necessary mean that it is better. Whilst there might be some appeal in a super-complicated black box trading strategy which has amazing returns, I for one would have difficulty running such a trading strategy with my own money! If a trader has no idea why a trading system is undertaking a trade, it becomes very difficult to remain invested in a strategy when it starts to perform poorly.
The inclination is simply to throw away such a model when performance starts to deteriorate. By contrast, when a trading strategy is simpler and a trader can understand why it is making or losing money, it is easier to allocate capital to it and to have some confidence in it. Keep trading ideas simple: the detail is in the precise implementation.
So what is the value of perpetuating the idea of some “secret sauce” that is based upon some very novel trading idea, rather than saying it is related to the precise details of an implementation? If anything, from a marketing perspective there is value in framing a strategy as more complicated than it really is. If a fund is trying to attract investors, it probably does not want to say it is just running the same strategy as all its competitors with a few interesting tweaks (my definition of “secret sauce”).
This is probably more difficult to sell as an idea, even if the strategy performs far better than competitors. Hence, sometimes excessive secrecy in a trading strategy has the added by-product of creating mystique. When something is unobtainable or has some element of mystique around it, it suddenly becomes that bit more appealing. I would call this excessive secrecy and mystique which accompanies trading strategies the “cinnamon complex,” harking back to Herodotus’ outlandish explanation for the origin of cinnamon.
This “cinnamon complex” can work both ways, however. For example, if a fund’s strategy is totally opaque, investors might not be so willing to hand over capital to invest, regardless of the performance. They might also be less willing to accept periods of under performance, which are inevitable for any trader.
From a trading perspective, the benefits of being secretive are largely dependent upon the capacity of a trading strategy within the market. If we are running a trading strategy which trades on a lower frequency, we might be able to be more open about the general idea, given that it is less likely the strategy could be crowded out quickly. This might not be true of very high-frequency strategies, where any leakage about the precise details of a strategy or even the general idea behind it could blunt its effectiveness through crowding out. In this instance, perhaps the “cinnamon complex” is more justified than in other parts of the market.
There is another point against the idea of a “secret sauce” relating to a very novel trading idea. Trading strategies do not work forever without some element of adaptation through time, especially when they are more specialized and have more characteristics associated with alpha. This is true in particular when the market capacity is less, such as in high-frequency strategies, when too many investors are chasing the same strategy.
Indeed, my personal experience of having real money invested in strategies that I have developed and my discussions with traders seems to add credence to this point. I remember running a profitable intraday FX strategy for just over 12 months with real cash at Lehman Brothers several years ago.
Ironically, in theoretical simulation it did extremely well in the weeks following the Lehman bankruptcy, although for obvious reasons Lehman Brothers was never able to run the strategy with real cash during that period, given it was a bankrupt institution! However, the last time I looked at the very same strategy, several years later, it had become unprofitable. There could be several reasons for this. We might suspect that the strategy had been crowded out.
However, I suspect the more important reason was simply a change in the way the market traded with the advent of quantitative easing. Later strategies I developed, whilst having some similar characteristics, were profitable. Hence, the ability to continually come up with new ideas, especially if we are seeking alpha, is necessary if one is to be an effective trader, and can also be part of the idea of a “secret sauce.”
Trading strategies do not work forever without some element of adaptation through time, especially when they are more specialized
It is a misconception that some within the market think they can run someone else’s trading strategy without having knowledge of all the various intricacies. If you have not spent the time developing an idea and are not familiar with the details, it is very often difficult to begin trading it. Yes, you might be able to place some risk on it and even profit from it, but what would happen if the strategy starts to develop problems? It amounts to not having a clear understanding of the risks involved.
This brings us back to our point about black box trading systems, where we have no idea why they are generating specific trades: when they go wrong, the only solution is to turn off the system, even though it could mean missing out on future outperformance. We describe how certain trading strategies will suit different traders. Very often different investors will also have varying ideas on how to construct their investment targets.
It’s all about implementation
In summary, my opinion is that the “secret sauce” is more a case of a trading strategy known to market participants which has been implemented very well, rather than a single overriding near-mythical idea. It is likely that it is the subtle details that make the difference between profitability and mediocrity. These details constitute the strategy’s “secret sauce.” There is certainly a case for protecting these details, to give a competitive advantage. It can also be the case that the continual improvement of a strategy over time can end up constituting a “secret sauce.”
I think it is more the case that marketing (or excessive secrecy, which we named the “cinnamon complex”) is the likely reason why some investors seem to think there is a “secret sauce,” based on very unusual trading approaches. In some cases, this type of secrecy might be justified if a strategy has very low capacity and the spread of the idea might render it unprofitable. However, in cases where capacity is high, perhaps this is more of a marketing exercise.
The lack of a “secret sauce” based upon very unusual trading strategies explains why strategies between competing funds can be correlated (as you would expect). At the same time, the differences in the details of implementation go some way towards explaining the relatively large discrepancies in the performance of what appear to be similar funds.
This material is adapted from a recent book authored by Saeed Amen, Trading Thalesians – What the ancient world can teach us about Trading Today, which is available on Amazon.