The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (8 page)

Huge, sudden leaps were a contingency no one bothered to consider. 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 down
year 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 known as statistical arbitrage, or stat arb—one of the most powerful trading strategies ever devised, a nearly flawless moneymaking system that could post profits no matter what direction the market was moving.

It was right up Thorp’s alley.

Gerry Bamberger
discovered stat arb almost by accident. A tall, quick-witted Orthodox Jew from Long Island, he’d joined Morgan Stanley in 1980 after earning a degree in computer science at Columbia University. At Morgan, he was part of a group that provided analytical and technical support for the bank’s stock trading operations.

In this capacity, Bamberger wrote software for Morgan’s block trading desk, which shuffled blocks of ten thousand or more shares at a time for institutional clients such as mutual funds. The block traders also used a “pairs strategy” to minimize losses. If the desk held a block of General Motors stock, it would sell short a chunk of Ford that would pay off if the GM stock took a hit. Bamberger’s software provided traders up-to-date information on the relative positions of the pairs.

Bamberger noticed that large block trades would often cause the price of the stock to move significantly. The price of the other stock in the pair, meanwhile, barely moved. This pushed the typical gap between the two stock prices, the “spread,” temporarily out of whack.

Suppose GM typically traded for $10 and Ford for $5. A large buy order for GM could cause the price to rise temporarily to $10.50. Ford, meanwhile, would stay at $5. The “spread” between the two stocks had widened.

By tracking the historical patterns and moving with cheetah-quick speed, Bamberger realized he could take advantage of these temporary blips. He could short a stock that had moved upward in relation to its pair, profiting when the stocks returned to their original spread. He could also take a long (or short) position in the stock that hadn’t moved, which would protect him in case the other stock failed to shift back to its original price—if the historical spread remained, the long position would eventually rise.

Much like Thorp’s delta hedging strategy, it was the old game of buy low, sell high, with a quant twist.

After describing his ideas to his superiors, Bamberger was set up on Morgan’s equity desk in early 1983 with $500,000 and a small group of traders. He started making buckets of cash right out of the gate. By September, his group had $4 million worth of long and short positions. In early 1984, it had $10 million. The stake rose to $15 million in October. By 1985, the group was running a $30 million book.

But almost as fast as Bamberger scaled the heights, he came crashing down. Morgan’s higher-ups, reluctant to leave such a money machine in the hands of a programmer, turned it over to a hired gun named Nunzio Tartaglia. Bamberger, outraged, quit the firm.

The Brooklyn-born Tartaglia was a mass of contradictions. He’d earned a master’s degree in physics from Yale University in the early 1960s, then promptly joined the Jesuits. After five years, he left the seminary to earn a Ph.D. in astrophysics from the University of Pittsburgh. By the early 1970s, Tartaglia found himself working on Wall Street as a retail broker at Merrill Lynch. After Merrill, the peripatetic Tartaglia went to five other firms before landing at Morgan in 1984.

He renamed the group he’d taken over Automated Proprietary Trading, or APT, and moved it to a single forty-foot-long room on the nineteenth floor in Morgan’s Exxon Building headquarters in mid-town Manhattan. Tartaglia added more automation to the system, linking the desk to the New York Stock Exchange’s Super Designated
Order Turnaround System, or SuperDOT, which facilitated computerized trades. APT was soon trading so much that at times it accounted for 5 percent of the daily trading volume on the NYSE. The stat arb strategy earned $6 million in the first year Tartaglia ran the group. In 1986, it pulled in an eye-popping $40 million, then $50 million in 1987. The group started to gain legendary status on Wall Street, in part due to its CIA-like secrecy.

In 1986, Tartaglia hired David Shaw, a computer whiz teaching at Columbia University, to head APT’s technology unit. The Stanford-educated Shaw was an expert in a hot new field called parallel processing, in which two or more mainframe computers crunched numbers on the same problem to ramp up speed and efficiency. Shaw had virtually no trading experience, but he was a quick learner, and soon became interested in the group’s unique trading strategies. His colleagues found him shy, nervous around women, and self-conscious about his looks. Tall, thin as a spider, Shaw dabbled in the early computer dating services springing up in the 1980s—in other words, he was a classic quant.

Morgan had hired Shaw with the promise that he’d be able to develop his own trading strategies, where the real money was to be made. But as Tartaglia steadily took over the group, making every effort to keep the lucrative trading platform to a chosen few, Shaw realized that he wouldn’t have the opportunity to trade.

He decided to take matters into his own hands. One day in September 1987, the group was giving a presentation about its business model and trading strategies to senior management. Shaw’s presentation on parallel processing and high-speed algorithms was proceeding normally. Suddenly, he started to expound on complex mathematical bond-arbitrage strategies. As the meeting ended, APT’s traders and researchers sat fuming in their chairs. Shaw had crossed the line. Programmers weren’t supposed to trade, or even think about trading. Back then, the line between programmer and trading strategist remained firmly in place, a boundary that steadily dissolved as trading became more and more computerized.

For his part, Shaw had hoped that Morgan’s higher-ups would see the value of his ideas. He’d also approached upper management
on his own about creating an entirely new research unit, a scientific laboratory for research on quantitative and computational finance. But his ideas fell on deaf ears, and Tartaglia wasn’t giving any ground. The weekend after the presentation, Shaw decided to quit, informing Tartaglia of his decision the following Monday. Tartaglia, possibly perceiving Shaw as a threat, was happy to see him go.

It may have been one of the most significant losses of talent in the history of Morgan Stanley.

Shaw landed on his feet, starting up his own investment firm with $28 million in capital and naming his fund D. E. Shaw. It soon became one of the most successful hedge funds in the world. Its core strategy: statistical arbitrage.

Tartaglia, meanwhile, hit a rough patch, and in 1988, Morgan’s higher-ups slashed APT’s capital to $300 million from $900 million. Tartaglia amped up the leverage, eventually pushing the leverage-to-capital ratio to 8 to 1 (it invested $8 for each $1 it actually had in its coffers). By 1989, APT had started to lose money. The worse things got, the more frantic Tartaglia became. Eventually he was forced out. Shortly after, APT itself was shut down.

In the meantime, Bamberger had found a new home. One day after he’d left Morgan, he got a call from Fred Taylor, a former Morgan colleague who’d joined a hedge fund that specialized in quantitative investing.

“What’s it called?” Bamberger asked.

“Princeton/Newport Partners,” Taylor told him. “Run by a guy named Ed Thorp.”

Thorp, Taylor explained, was always interested in new strategies and was interested in looking at stat arb. Taylor introduced Bamberger to Jay Regan, and the two hit it off. Thorp and Regan agreed to back a fund called BOSS Partners, an acronym for Bamberger and Oakley Sutton Securities (Oakley and Sutton are Thorp and Regan’s middle names, respectively). Bamberger set up shop in a 120-square-foot twelfth-floor office on West 57th Street in New York. With $5 million in capital, he hit the ground running, cranking out an annualized return of about 30 percent his first year in operation. By 1988, BOSS
was running about $100 million in assets and generating consistent double-digit returns.

BOSS, like APT, hit a dry spell in early 1988. Toward the end of the year, Bamberger decided he’d had enough of Wall Street. He wound down BOSS and moved upstate to teach finance and law at the State University of New York at Buffalo. He never again traded stocks on a large scale.

But his strategy lived on, and not just at Princeton/Newport. Traders who’d worked for Bamberger and Tartaglia fanned out across Wall Street, bringing stat arb to hedge funds and investment banks such as Goldman Sachs. As D. E. Shaw raked in profits, other funds started trying to copy its superfast trading style. Robert Frey, who’d worked as an APT researcher, took stat arb to Jim Simons’s fund, Renaissance Technologies, in the early 1990s. Peter Muller, the singing quant who triumphed at Wall Street Poker Night in 2006, appeared on the scene at Morgan a few years after Tartaglia was ousted and started up his own stat-arb money machine, one that proved far more robust. Ken Griffin, who kept a keen eye on everything Thorp was doing, adopted the strategy at Citadel. Stat arb soon became one of the most popular and consistent ways to make money on Wall Street—too popular, in fact, as its practitioners would discover in August 2007.

Ed Thorp’s influence was spreading across the financial universe in other ways as well. At MIT, a team of blackjack card counters sprung up, the group that would eventually inspire the bestselling book
Bringing Down the House
. An early member of the group was a young math hotshot named Blair Hull, who’d read
Beat the Dealer
in the early 1970s. By the end of the decade, he’d parlayed $25,000 in winnings to jump-start a trading career in the Chicago options trading pits, having also read
Beat the Market
. In 1985, he founded Hull Trading, which specialized in using quantitative models and computers to price options on a rapid-fire basis. Hull eventually became one of the most advanced trading operations in the world, a quant mecca that transformed the options world. In 1999, Goldman Sachs shelled out $531 million for Hull, which it developed into one of Wall Street’s premier high-frequency trading outfits.

For Thorp and Regan, meanwhile, everything had been running smoothly. The fund had posted solid gains in 1986 and was surging ahead in the first half of 1987, helped by BOSS’s gains. Then stocks started to wobble. By early October, cracks were forming in the market that would turn into a full-blown earthquake. At the heart of the disaster: the quants and the Black-Scholes option-pricing formula.