Nerds on Wall Street: Math, Machines, and Wired Markets

3.8. Known Unknowns and Unknown Unknowns

Almgren and Chriss close with an important point about the limitations of all model-driven strategies. As part of the Algos 201 track, here is what they say about connecting algorithms to real-world events:

Finally, we note that any optimal execution strategy is vulnerable to unanticipated events. If such an event occurs during the course of trading and causes a material shift in the parameters of the price dynamics, then indeed a shift in the optimal trading strategy must also occur. However, if one makes the simplifying assumption that all events are either "scheduled" or "unanticipated," then one concludes that optimal execution is always a game of static trading punctuated by shifts in trading strategy that adapt to material changes in price dynamics. (p. 5)

This is a Ph.D.-ified version of the wisdom of two-time Secretary of Defense Donald Rumsfeld that there are "known unknowns and unknown unknowns."

Examples of known unknowns include scheduled announcements that affect particular stocks, like earnings releases or conference calls; announcements that affect groups of stocks, like housing starts; and announcements that affect broad markets, like macroeconomic data and interest rates.

There are many sources of this type of information. Thomson's StreetEvents offers a wide selection. Econoday is a calendar book for information on the latter two types of events just mentioned. Found in calendar form in every trading room since the 1950s, ...