Inside the Black Box: The Simple Truth About Quantitative Trading

3.1. TYPES OF ALPHA MODELS: THEORY DRIVEN AND DATA DRIVEN

An important and not widely understood fact is that there are only a small number of trading strategies that exist for someone seeking alpha. But these basic strategies can be implemented in many ways, making it possible to create an incredible diversity of strategies from a limited set of core ideas. The first key to understanding quant trading strategies is to understand the perspectives quants take on science.

Because most quants are trained first in the sciences and only later in finance, quants' scientific backgrounds frequently determine the approach they take to trading over their entire careers. The two major branches of science, which also serve as a helpful way to differentiate scientists, are theoretical and empirical. Theoretical scientists try to make sense of the world around them by hypothesizing why it is the way it is. This is the kind of science with which people are most familiar and interact most. For example, viable, controllable, long-distance airplanes exist largely because engineers apply theories of aerodynamics. Empirical scientists believe that enough observations of the world can allow them to predict future patterns of behavior, even if there is no hypothesis to rationalize the behavior in an intuitive way. In other words, knowledge comes from experience. The Human Genome Project is one of many important examples of the applications of empirical science, mapping human traits to the sequences ...