Inside the Black Box: The Simple Truth About Quantitative Trading

2.2. WHAT IS THE TYPICAL STRUCTURE OF A QUANTITATIVE TRADING SYSTEM?

The best way to understand both quants and their black boxes is to examine the components of a quant trading system; this is the structure we will use for the remainder of the book. Exhibit 2.1 shows a schematic of a typical quantitative trading system. This diagram portrays the components of a live, "production" trading strategy (e.g., the components that decide which securities to buy and sell, how much, and when) but does not include everything necessary to create the strategy in the first place (e.g., research tools for designing a trading system).

The trading system has three modules—an alpha model, a risk model, and a transaction cost model—which feed into a portfolio construction model, which in turn interacts with the execution model. The alpha model is designed to predict the future of the instruments the quant wants to consider trading for the purpose of generating returns. For example, in a trend-following strategy in the futures markets, the alpha model is designed to forecast the direction of whatever futures markets the quant has decided to include in his strategy.

Risk models, by contrast, are designed to help limit the amount of exposure the quant has to those factors that are unlikely to generate returns but could drive losses. For example, the trend follower could choose to limit his directional exposure to a given asset class, such as commodities, because of concerns that too many forecasts ...