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A Physicist on Wall Street. John Krane Third Millennium Trading Downtown Chicago. I don’t actually work on Wall Street, but “A Physicist on Van Buren Street” doesn’t have the same ring to it…. 8 September, 2005. Personal Bkgnd. University of South Dakota

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a physicist on wall street

A Physicist on Wall Street

John Krane

Third Millennium Trading

Downtown Chicago

I don’t actually work on Wall Street,but “A Physicist on Van Buren Street”doesn’t have the same ring to it…

8 September, 2005

personal bkgnd
Personal Bkgnd

University of South Dakota

  • B.S. Bus. Admin. – Management…plus Math, Philosophy, Chemistry, Music, Economics…found Physics
  • B.S PhysicsUniversity of Nebraska -- Lincoln
  • M.S. Physics, minor Mathematics
  • Ph.D. Physics, “The Ratio of Inclusive Jet Cross Sections at sqrt(s) = 630 and 1800 GeV”, plus W cross section at 630 GeV
  • GSA 1996-97

Iowa State University

  • Pit fighting
  • Global Tracking code (kalman/root/C++)
  • QCD Group Convenor
  • jet algorithm work (Matthais Toennesmann)
  • Neutrino Mag. Moment (Fritz DeJongh)
  • YPP 2000-01
  • 8 years total at FNAL

Give me analysisor give me death!

John Krane – Third Millennium Trading

kalman filter vs particle filter

By the way…

Kalman Filter vs. Particle Filter
  • Standard Kalman filter – Gaussian errors, linear problem
    • Extended Kalman Filter – Gaussian errors, non-linear problem (Taylor)
    • “Unscented” Kalman Filter – Gaussian errors, non-linear problem (coordinate transformation)
  • Particle Filter – non-Gaussian errors! (a Monte Carlo technique)

True path

Best fit…too bad it’s impossible!

Kalman assumes

Position probability is really

cf: “The Unscented Particle Filter”, van der Merwe, Doucet, Freitas, Wan

John Krane – Third Millennium Trading

what is a quant
What is a “Quant”?
  • Fundamental Financial Analyst: Price/Earnings ratios, global economy, demand for products
    • MSNBC
    • Financial reports company by company
  • Quantitative Financial Analyst: large data sets of historical prices, etc, and statistical models
    • Data mining, pattern recognition, analysis
  • Technical Analyst:moving average trend lines,Elliot wave theory, visual patterns in pricing (“cup and bowl”, “evening star”)
    • Generally not well-founded in statistics

John Krane – Third Millennium Trading

third millennium trading

TMT: 3 Big Bosses 5-15 Floor Traders 5 Prop. Trad. Desk+ me, Dennis, Mark

Third Millennium Trading
  • Market MakerYou want to sell 1000 options contracts, we buy them at the bid price. They want to buy 1000 contracts, we sell them at the ask price.

On average, a market maker collects the bid/ask spread and has no market risk. They are paid to provide liquidity (like eBay does for garage sales)

  • Proprietary TradingTrades to make money from owning or shorting the instruments. Can acquire position in the course of MM-ing.

John Krane – Third Millennium Trading

stocks equities
Stocks (Equities)
  • Derive value from
    • Old school: the size and likelihood of dividend payment
    • New school: from a company’s (perceived) worth
  • Can buy them (“go long”) or sell them (“go short”)Can sell stock without actually owning it, but you must provide collateral in an account
  • Pairs trading: go long and short in two closely-related stocks
    • If the entire market unexpectedly loses value, both stocks move similarly and you are protected
    • Essentially, you are making a bet on mean-reversion
  • Basket trading: generalization of pairs trading
    • per/stock costs can hurt profits

all these stock concepts apply to other instruments

John Krane – Third Millennium Trading

models for stock prices
Models for Stock Prices

Example of autoregression:

or any other time series…

Prices are a time series (fractional daily s = 1%) modeled with: autoregression, nearest neighbor, min/max, voodoo

®hard to beat the Random Walk Model (future price = current price + e)

Fibonacci numbers anyone?

Histo: actual 30-sec price for a 3-stock basketYellow blocks: actual 20-min average price

Dots: A mass-and-spring modelThe more aggressive the model, the bigger themistakes at market reversals! Random walk does better than this model

John Krane – Third Millennium Trading

some details

Costs: commission, bid/ask spread, usu. 2.5¢/share

Some details
  • A trading company is allowed to provide less money than the stock value (2:1 leverage)…required whether short or long
  • Trading rules for robots: Buy/Sell signal, stop-loss, profit-take signal, chicken-out, time-limit
  • Have to beat 40% / year ROI … most of my attempts with stocks could not overcome costs! → hard to predict direction of short-term price moves

Thus we don’t trade stocks for profit!

John Krane – Third Millennium Trading


Costs/contract: ~ $10/commis + $30 bid/ask + 20% margin

  • A standardized contract to buy or sell goods at a set priceE.g.: 40,000 lbs live hogs @ $47/100lbs in March
  • A good way to remove uncertainty for farmers
  • Speculators don’t actually have to buy the goods, instead just sell before expiry …anybody want 40,000 lbs butter?
  • Can also go short = agree to sell them in the future without owning them now
  • Oil, gasoline, heating oil, gold, platinum, silver, copper, wheat, cheese, milk, urea

John Krane – Third Millennium Trading

stock options a kind of insurance
Stock Options…a kind of insurance
  • For $5, you get a contract allowing purchase of 100 shares of X at $K/share in Z months (can also go short of course)
  • After Z months, if the price $S is higher than $K, you “exercise the option” and pocket $(S-K)*100 “cash settlement”
  • If the price $S is less than $K, let the option expire and you only waste $5

K is the “strike price”

American options allow early exercise

The contract finished “in the money”

The contract finished “out of the money”

John Krane – Third Millennium Trading

a little stochastic calculus

Random walk model again…

A little Stochastic Calculus
  • Assume stock prices follow geometric Brownian motion:
  • The expectation of the stock price distribution is lognormal(i.e., Ln(S) is Gaussian)
  • 1973 Fischer Black, Myron Scholes, Robert Merton publish (will win “Nobel” prize for Economics with) the above and their option pricing formula.

Frac. Price change = drift + random motion

John Krane – Third Millennium Trading

error bands in physics often lognormal

By the way…

Error bands in physics, often lognormal!

should be

  • If distribution can’t go negative (e.g. a cross section), mis-measurements resulting from the error usually lognormal…not Gaussian.
  • In Run I, DÆ QCD had an elegant way to represent lognormal error effects in (D-T)/T

Does a fractional error make sense? If so, deviations due to the error are lognormal.

Thanks Iain Bertram

John Krane – Third Millennium Trading

dynamic option hedging the greeks
Dynamic Option Hedging – “the greeks”
  • Find the variation of your options position w.r.t.
  • Sell offsetting stock (D=1.0) to suppress price sensitivity.
    • If your option was originally mispriced, you make money if the market moves up or down!
    • Mispricings usu. result from misprediction of price volatility (s)
    • Short options = selling insurance that the price won’t change
    • Long options = buying such insurance
    • You can add D for your portfolio to see if you are “net long” or “net short”

Stock price

2nd w.r.t. price



Traders often know littlePDE, but they know“the greeks”

= D dS + Q dt + V d + G dS)2

John Krane – Third Millennium Trading

re hedging heuristic
Re-hedging heuristic

A long options position

Consider a long, hedged option positionat-the-money (S=K) at t=0:Profit<0 due to costs

If D=0, slope = 0


Stock price

Unrealized gain

Profits increase “on paper” when the price moves from hedged price


Stock price

Even if price returns to original,we don’t lose the captured profit…now that’s worth a Nobel Prize…

Re-hedge at new price…

Profits captured!


Stock price

The valley gets more shallow away-from-the-money (i.e. G→0)

John Krane – Third Millennium Trading

re hedging
  • For a “delta-neutral” and “vega-neutral” portfolio
  • Clearing house always demands approximate delta-neutrality (or a really good risk-dispersion model)
  • Second term is “jump risk”. If a stock price changes by 30%, a short position could tank even if you were delta-neutral

A short options position:here, you hope the pricenever moves


Stock price

John Krane – Third Millennium Trading

what do i do with my time
What do I do with my time?
  • Options model, running for 1+ years, modifiedPredicting volatility is key, watch out for jumps!
  • Commodities model (energy/metals)“paper trading” it now, shows promise, need courage
  • Stock trading…investigated 3 times!What is a good predictor and what is noise?
  • International index funds, foreign currency exchange
  • Not yet: bonds, exotic options, VIX

John Krane – Third Millennium Trading

can you beat goldman sachs
Can you beat Goldman Sachs?
  • There are many big players (GS, Merryl Lynch, hedge funds galore)
  • But moving big money also moves the market
  • Exploit small mispricings they cannot
  • Have visualization tools they don’t
  • Have training they don’t
  • I’m better (and more full of myself) than they are

Pride, arrogance, andhubris…Oh my!

John Krane – Third Millennium Trading

a typical day for me

8:30am market open

3:00pm market close

A typical day for me
  • Up at 5:30, train at 6:30, office at 7:50“work trader’s hours”
  • 9:00 collect stock price data, update trees, predict volatility, find options mispricings, check plots, email results to Mark, IM a summary
  • 9:30 – 2:30 research of my choice
  • 2:30 collect comodities price data, find energy/metals mispricings, paper trade, email summary to Mark
  • 3:05 re-collect closing stock price data
  • 3:20-4:45 leave for train, home 5-6pm
  • We use(d):
  • ROOT
  • Matlab
  • MySQL
  • Excel/Access
  • Minuit
  • Private libs

John Krane – Third Millennium Trading

careers in finance
Careers in Finance
  • Coder (C#, C++, SQL, perl)Easy to get if you have the skills
  • Junior Quant (join a big company)Difficult to get, need to test well
  • Insurance Analyst, etc.Very concerned with non-Gaussian prob.Monte Carlo
  • New Effort (small team getting started)Rare opportunity
  • Temp JobsRecoding existing work, analysis miracles, anything in between

Where are the jobs for Ph.Ds?

  • London
  • New York City
  • Eastern USConn, NJ, Bahamas
  • Chicago
  • Elsewhere

John Krane – Third Millennium Trading

prediction company

The Predictors, Thomas A. Bass

Prediction Company
  • Doyne Farmer, Norman Packard leave Los Alamos and a U. of IL to found company in Sante Fe (1991)
  • Chaos theory just doesn’t work in financial markets
  • They try other means, as discussed earlier
  • Farmer returns to academia (Sante Fe Institute)
  • Packard still runs Prediction Co., 25% owned by UBS
  • See also D.E. Shaw (NY) and Citadel (Chi.)

So don’t tell meabout it….


John Krane – Third Millennium Trading

how to prepare
How to prepare
  • Books:
    • “Options, Futures, and Other Derivatives,” John C. Hull ($150)Like Jackson’s Electrodynamics…good and bad
    • “Market Models,” Carol Alexander ($90)Advanced, interesting, useful
    • “Quantitative Finance and Risk Management: A Physicist’s Approach,” Jan W. Dash ($100) Written by physicist, odd notation, Reggeon Field Theory?
    • “Option Volatility and Pricing,” Sheldon Natenberg ($40)Very introductory, math in the appendix, helps you talk to traders
    • “My Life as a Quant,” Emanuel Derman ($20)Written by ex-physicist, quant apologist wishes he was physics theorist

My personal favorite

Dennis keeps taking it home…

John Krane – Third Millennium Trading

more how to prepare
More: How to prepare
  • Web sites:
    • www.numa.com→ employment offered/wanted
    • Wilmott.com forums
    • Monster.com, careerbuilder.com
  • Grow your skill set
    • Review want ads and learn skills they demand!
  • Grow a thick skin
    • Recruiters can be brutal
    • Many Masters-level programs (e.g. U.Chicago) teach this stuff directly…

Look here first!

John Krane – Third Millennium Trading

reasons to love it
Reasons to Love It
  • Positive:
    • Analysis (large data sets, pattern recognition, data mining)
    • Linking sub-analyses into a result, then a working system
    • Objective measure of goodness (fïckle peer-approval not so relevant)
    • Be your own scientist, trusted to find most fruitful path (in my job anyway)
    • Some probability of doing real short-term social good
    • Physics seems fairly mature, Economics is certainly not
    • Great parties…
  • Missing negatives:
    • No hustling for grant money
    • No computing division
    • No email avalanche, no culture of workaholism
    • No conference schedule…work is done when its ready
    • No teaching load
    • No politicization of results
    • No career bottle-neck


My papers are 3 pages, my “grant” is 10

  • Negatives:
    • No foreign travel
    • Barrier for women

John Krane – Third Millennium Trading

  • Directions of stock price movements are very hard to predictPrice volatility, price relationships much easier to predict
  • Pairs/baskets insulate you from market tides, but costs multiplyApplies to portfolios of stocks/options/whatever
  • Options + dynamic hedging = quadratic profit/loss curve → if long: make money if market goes up or down! → if short: must hedge as frequently as you can afford …but often the price changes while the market is closed
  • Quant analysis/experimental physics analysis very similar
  • Ph.D.s common in finance, not always better, not always respected, so don’t expect a red carpet
  • Finance is not a mundane job you will hateI feel challenged, I don’t do the same things every day, I have my academic freedom, I like my bosses

in my experience

John Krane – Third Millennium Trading

contact info
Contact Info
  • Dr. John Kranehttp://home.comcast.net/~jkrane/312 260 5220 (10am-1pm is best)

jkrane_at_netzero_dot_comjust replace the _at_ and the _dot_…

Contact me any time, and I mean that. My company is not hiring, and we have no plans to do so, but I’m happy to look at your resume and make suggestions, etc.

John Krane – Third Millennium Trading