The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It by Scott Patterson Page B
Authors: Scott Patterson
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Experienced traders such as Thorp understood this and made adjustments accordingly—his paranoid hand-wringing about distant earthquakes or nuclear bomb attacks, as well as his constant attention to the real odds of winning essential for his Kelly calculations, kept him from relying too much on the model. Other quantitative traders, less seasoned, perhaps less worldly, came to see the model as a reflection of how the market actually worked. The model soon became so ubiquitous that, hall-of-mirrors-like, it became difficult to tell the difference between the model and the market itself.
In the early seventies, however, the appearance of the Black-Scholes model seemed propitious. A group of economists at the University of Chicago, led by free market guru Milton Friedman, were trying to establish an options exchange in the city. The breakthrough formula for pricing options spurred on their plans. On April 26, 1973,one month before the Black-Scholes paper appeared in print, the Chicago Board Options Exchange opened for business. And soon after, Texas Instruments introduced a handheld calculator that could price options using the Black-Scholes formula.
With the creation and rapid adoption of the formula on Wall Street, the quant revolution had officially begun. Years later, Scholes and Robert Merton, an MIT professor whose ingenious use of stochastic calculus had further validated the Black-Scholes model, would win the Nobel Prize for their work on option pricing. (Black had passed away a few years before, excluding him from Nobel consideration.) Thorp never received any formal recognition for devising essentially the same formula, which hadn’t fully published. He did, however, make hundreds of millions of dollars using it.
Princeton/Newport Partners had garnered so much attention by 1974 that the
Wall Street Journal
ran a front-page article on the fund: “Playing the Odds: Computer Formulas Are One Man’s Secret to Success in the Market.”
“Reliable brokerage-house sources close to the funds say they have averaged better than 20 percent a year in net asset growth,” the article said. More remarkable, such gains came at a time when the market was experiencing its worst decline since the Great Depression, rocked by high inflation and the Watergate scandal. In 1974, a year that saw the S&P 500 tumble 26 percent, Thorp’s fund gained 9.7 percent.
The article went on to describe one of the world’s most sophisticated investing operations—and the germ for the quant revolution to come. Thorp, it said, “relies on proprietary mathematical formulas programmed into computers to help spot anomalies between options and other convertibles and their common stock. … Mr. Thorp’s funds are an example of an incipient but growing switch in money management to a quantitative, mechanistic approach, involving heavy use of the computer.”
Starting in the mid-1970s, Princeton/Newport went on a hot streak, posting double-digit returns for eleven straight years (after the 20 percent incentive fees Thorp and Regan charged clients, typical for hedge funds). In fact, from its inception, the fund never had a downyear or a down quarter. In 1982, Thorp quit his teaching job at UC Irvine and started working full-time managing money.
The gains kept coming, even in down years. In the twelve months through November 1985, Princeton/Newport was up 12 percent, compared with a 20 percent decline by the S&P 500. By then, Thorp and Regan were managing about $130 million, a heady increase from the $10,000 stake Thorp had received from Manny Kimmel for his first blackjack escapade in 1961. (In 1969, when the fund opened its doors for business, it had a stake of $1.4 million.)
But Thorp wasn’t resting on his laurels. He was always on the lookout for new talent. In 1985, he ran across a hotshot trader named Gerry Bamberger who’d just abandoned a post at Morgan Stanley. Bamberger had created a brilliant stock trading strategy that came to be
In the early seventies, however, the appearance of the Black-Scholes model seemed propitious. A group of economists at the University of Chicago, led by free market guru Milton Friedman, were trying to establish an options exchange in the city. The breakthrough formula for pricing options spurred on their plans. On April 26, 1973,one month before the Black-Scholes paper appeared in print, the Chicago Board Options Exchange opened for business. And soon after, Texas Instruments introduced a handheld calculator that could price options using the Black-Scholes formula.
With the creation and rapid adoption of the formula on Wall Street, the quant revolution had officially begun. Years later, Scholes and Robert Merton, an MIT professor whose ingenious use of stochastic calculus had further validated the Black-Scholes model, would win the Nobel Prize for their work on option pricing. (Black had passed away a few years before, excluding him from Nobel consideration.) Thorp never received any formal recognition for devising essentially the same formula, which hadn’t fully published. He did, however, make hundreds of millions of dollars using it.
Princeton/Newport Partners had garnered so much attention by 1974 that the
Wall Street Journal
ran a front-page article on the fund: “Playing the Odds: Computer Formulas Are One Man’s Secret to Success in the Market.”
“Reliable brokerage-house sources close to the funds say they have averaged better than 20 percent a year in net asset growth,” the article said. More remarkable, such gains came at a time when the market was experiencing its worst decline since the Great Depression, rocked by high inflation and the Watergate scandal. In 1974, a year that saw the S&P 500 tumble 26 percent, Thorp’s fund gained 9.7 percent.
The article went on to describe one of the world’s most sophisticated investing operations—and the germ for the quant revolution to come. Thorp, it said, “relies on proprietary mathematical formulas programmed into computers to help spot anomalies between options and other convertibles and their common stock. … Mr. Thorp’s funds are an example of an incipient but growing switch in money management to a quantitative, mechanistic approach, involving heavy use of the computer.”
Starting in the mid-1970s, Princeton/Newport went on a hot streak, posting double-digit returns for eleven straight years (after the 20 percent incentive fees Thorp and Regan charged clients, typical for hedge funds). In fact, from its inception, the fund never had a downyear or a down quarter. In 1982, Thorp quit his teaching job at UC Irvine and started working full-time managing money.
The gains kept coming, even in down years. In the twelve months through November 1985, Princeton/Newport was up 12 percent, compared with a 20 percent decline by the S&P 500. By then, Thorp and Regan were managing about $130 million, a heady increase from the $10,000 stake Thorp had received from Manny Kimmel for his first blackjack escapade in 1961. (In 1969, when the fund opened its doors for business, it had a stake of $1.4 million.)
But Thorp wasn’t resting on his laurels. He was always on the lookout for new talent. In 1985, he ran across a hotshot trader named Gerry Bamberger who’d just abandoned a post at Morgan Stanley. Bamberger had created a brilliant stock trading strategy that came to be
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