3.2. Algos for Alpha

Early adopters of these ideas were not looking to minimize market impact or match volume-weighted average price (VWAP). They were looking to make a boatload of cash, and willing to commit firm capital to do so.[] Nunzio Tartaglia, a Jesuit-educated Ph.D. physicist with the vocabulary of a sailor, started an automated trading group at Morgan Stanley in the mid-1980s. He hired young Columbia computer science professor David Shaw. At first, a few papers about hooking Unix systems to market systems emerged. Then the former academics realized there was no alpha in publications. Shaw went on to found D.E. Shaw & Company, one of the largest and most consistently successful quantitative hedge funds. Fischer Black's Quantitative Strategies Group at Goldman Sachs were algo pioneers. They were perhaps the first to use computers for actual trading, as well as for identifying trades.

The early alpha seekers were the first combatants in the algo wars. Pairs trading, popular at the time, relied on statistical models. Finding stronger short-term correlations than the next guy had big rewards. Escalation beyond pairs to groups of related securities was inevitable. Parallel developments in futures markets opened the door to electronic index arbitrage trading.

Automated market making was a valuable early algorithm. In quiet, normal markets buying low and selling high across the spread was easy money. Real market makers have obligations to maintain a two-sided quote for their ...

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