Inside the Black Box: The Simple Truth About Quantitative Trading

9.2. IDEA GENERATION

Ideally, quants follow the scientific method in their research. In this regard the development of theories (or theoretically sound approaches to data mining) is the first key step in the research process. We find four common sources of ideas to be observations of the markets, academic literature, migration, and lessons from the activities of discretionary traders.

The main way that quants come up with their own ideas is by watching the markets. This approach most embodies the spirit of the scientific method. An excellent example comes from the history of the oldest of quant trading strategies: trend following in futures contracts. Richard Donchian is the father of trend following. He originally traded stocks, but in 1948, he created Futures, Inc., the first publicly held commodity fund. In December 1960, he published his philosophy toward trading in his newsletter, Commodity Trend Timing.^[] He observed that there are sweeping moves in many markets that folks tend to call bull or bear markets; he postulated that one could build a system that would detect that these trends had begun and then ride the wave. He translated his philosophy into the following strategy: If a given market's price is above the highest closing price over the past two weeks, buy that market. If its price goes below the lowest closing price over the past two weeks, sell that market short. In the meantime, hold whatever position you have in that market. Using this incredibly simple system, ...