basic economics of an algorithmic trading startup
Recently I had a thought-provoking email exchange with a reader of this blog. It was with a fellow who wanted to startup an algorithmic trading business and was seeking my advice. Its arrival was timely for me and I hope the advice I provided the aspiring entrepreneur was helpful.
The conversation forced me to reconsider familiar terrain from a different perspective, so I share it along with some further thoughts in the hope that it might act as something of a counter-weight to articles and blogs entreating you to “learn algo-trading!” (as though it were a fun! weekend hobby) or “make a million % trading the xyz” and more nefarious advertisements selling the trading equivalents of male-enhancement pills & potions (“I turned a used bus ticket and some pocket change into $7M in 2 months trading the e-mini!”).
I’ve changed the writer’s name and all identifying characteristics for obvious reasons. He wrote:
First of all I want to say I really enjoy your blog. I particularly like your latest portfolio of strategies that updates itself intraday while running a host of strategies in simulation.
I saw that you left Wall Street back in 2005; I am currently at [a 'money-center' bank in] London and am contemplating a similiar move. Was wondering if you have any advice or words of thought, particularly in this market/economic environment? My dream has always been to work at a small hf or high freq shop or to start one of my own. After several years, I finally think I have enough strategies and angles to go forward.
Btw, you are not at Tower Research, are you? They have t-shirts which read “Hack Wall Street”
Not knowing ‘Sean’ from Adam, I replied aiming to be helpful but with a characteristic dose of snark:
Thanks for your kind words – they’re appreciated.
I always have advice. Quality is the issue. That said, even my ordinarily low standards can’t be met w/o more info about you. (e.g., what kind of work have you been doing?, what kind of money do you have salted away (that you are willing to lose!)? etc etc).
But I can still make a few observations. My first is general:If you haven’t been working, directly, in a hedge fund or a hft shop, I wouldn’t recommend trying to start one on your own. Join one, understand all aspects of the business, build a track record and contacts and only then (if at all) attempt your own gig.
Regarding: “particularly in this market/economic environment” and “HFT”:
HFT is (wrongly, imo) currently under serious attack. Off-market derivatives and bought politicians were used to wreck economies, but HFT has become the scapegoat. I believe that [the bank you work at] has shut down their prop HFT biz and I know that [another bank] has. Many others go under every day. Whatever else this might mean, it certainly means that there will be fewer jobs and more qualified people on the street competing for them.
It also means there is a possibility (probably a small one) that some kind of regulatory action literally kills the field. A tobin tax or the like would mean the end of HFT. Which would make HFT an unfortunate business to be in…
Also, HFT is a *very* specialized field. You need to have very specialized skills to really add value. Only you can answer if you do or not.
Finally, a wise wall st old-timer once told me: “there are years to make a killing on your bonus and there are years to keep your job…”
Regarding: “a small hf”
Hedge funds are (mostly) a very different business from HFT shops. The successful hf mgrs I know all aver that the game is all about raising money – managing it is very secondary (unless you’re seriously foolish or a fraud). It also raises the question:
Most of all: What do you really want to do with your life?
Good luck to you. Best,
ps – I’m not sure that I’ve ever even heard of tower research…
This probably wasn’t what he wanted to hear and he came back a bit piqued at my necessarily ill-targeted advice:
Same clarifications if I may:1) When I said my dream was to start my own small hf or high freq shop, I should have stated that is my long-term goal. In the short term, I see myself working for a hedge fund first while also trading my own PA in respectable size (quant strategies, fully systematic).
2) I should state that I have run a $50M systematic book successfully at [London bank] albeit only on low frequency strategies. I have also worked at a very large prominent electronic market making desk at [London Bank]. So while this is not the same as have direct experience at a hedge fund, I dont consider myself a novice either. However, I agree that I am not ready to start my own hf or hf shop. My issue at the moment is I would like to focus more on the medium-to-high frequency end at the spectrum, but it appears this is not going to be possible at [London Bank].
3) I agree with many of the the things you stated about HF. Just curious, do you consider yourself a HF trader? I honestly consider myself more of a medium frequency/intraday with no overnight risk trader. I am definitely not ultra high frequency or doing any latency arb and I think “medium frequency” is a good place to be.
4) Question for you: do you consider a 6 figure PA account large enough to establish a track record in terms of hashing out if something indeed has an _actual_ out-of-sample edge? Granted this is not alot of money, but my assertion is that this is enough to “go live” with several systems _in very small size_ with strict money management. [ie no more than 2% risk per trade, absolute max 10:1 leverage, etc] And I am not starting from scratch; I have been in quant strategy for over 2 1/2 years and have several systems ready to go.
Where I am at now is that I am ready to do #4 full-time while continuing to interview with hedge funds and high freq shops. I have the right background Electrical and Computer Engineering from [top-tier American University], graduate work in time series analysis and econometrics from [top-tier UK biz school], [more impressive sounding experience] but it is taking longer than I had hoped to make the jump to the buy side.
I realize you are probably thinking “hold on to your job on the sell side at all costs etc..” as it is really bad at there and may likely get worse, and while I dont disagree, at some point a person has to move towards what they want instead of living in fear forever. Let’s just say the past couple of years in banking have not been enjoyable.
Sorry for ranting but hope you can understand where I am coming from…would appreciate any advice you may still have…
Sean had provided some useful information with which we could do some simple math. He had a good background and some hundreds of thousands of dollars he was willing to risk on the venture. Not bad, right?… I responded:
It all sounds reasonable and none of it sounds like a rant.
1,2 Sound good to me.
3 Definitely not ultra high. Many hundreds of trades per day at most for any given strategy.
4 Yes, but for what? Your (excellent) background is certainly no handicap (though many or most places require a phd for a quant position with p&l), so the question as to whether you can land the job you desire is an empirical one. Go for it! Certainly I wouldn’t recommend that you quit your job and start trading as that immediately puts you at a very substantial disadvantage from the perspective of employers. I empathize with the “past couple of years in banking have not been enjoyable,” but 6 figures of savings aren’t a ton if you’re used to living a banker’s lifestyle in an expensive financial center like nyc or the city. Going to the buy-side sounds like a great idea; quitting your job? – not so much.
Your decision will also depend on your position in life. If you have a family (or want to), a partner who enjoys spending money, a desire to travel, etc etc. Quitting your job to trade your own account is certainly ballsy and if you are successful then shazam! If not, then you may have irrevocably pushed yourself off the (successful if not enjoyable) path you’ve worked so hard to obtain; if economies really go down the tubes or bigger wars become fashionable, you could find yourself in a really funky spot. Or you could be wildly successful and build a giant sailboat that kick’s larry ellison’s butt…
Let me ask you a few questions. What platform(s) do you intend to use? Where will you get your data? How will you store it? Manage it? For me, back in 2005 I thought I’d just head on out there, buy some spiffy product and be off and trading. I was profoundly wrong about that. Retail level platforms are crap. Seriously unusable. (My info on this may be dated, I admit – hence my questions to you ) I don’t think you can afford an institutional platform with 6figures in the bank unless you are *immediately* profitable and burning through half your wad in a few months will impose stress that’s altogether more serious than whatever ridiculous nonsense I imagine you have to put up with at [London bank] these days. Building your own platform isn’t so easy and is quite time-consuming. Worse than that, it causes you to have to focus on a lot of things that are *not* central to your primary aim.
Let’s look at numbers. Say you have ~$500K in hand and a requirement of ~$100K to live. 20% seems plausible. But you will actually need to do rather better than 20%. Insurance costs are a mother (maybe not in the uk), but they’re a good deal less than usable office space, bandwidth and lots of other oddments you’ll find yourself paying (eg, accountants aren’t free, lawyers aren’t cheap, and programmers mostly suck). So, your real expenses aren’t 100K/year, but more like say 150K or worse. Oh yeah, there’s taxes, too. So, in reality starting from a 6figure base, you need to make ~30% or rather better to *break*even*. If you have a year in which you make less than your break-even point, then the numbers get really grim. On the other hand, you need to have a serious blowout year to make a significant difference in these basic numbers. There’s no margin for error or, worse, misfortune. Don’t get sick, don’t break an arm, don’t have a loved-one need anything from you and don’t lose any money! In spite of all of your experience, intelligence and hard work, a bit of bad luck can put you into an untenable position. There’s a good reason the Greeks believed that the only thing more powerful and less controllable than their rich pantheon of powerful Gods were The Fates.
All of this said, who the heck am I? Sounds like you have a great background and some passionate ideas about what you want to do. I don’t want to be negative or dissuade you from pursuing a dream. But I assume you’ve got all the up-side worked out and have thus focused on the (potential) down-side! ;^>
I haven’t heard back from Sean and at this point don’t expect to though I gave him as direct and honest advice as I was capable of providing.
a cautionary tale
This exchange resonated with me because, almost exactly five years ago I had a ‘serious’ conversation with my then-fiancée (and now wife and mother of our beautiful son). I had been working hard for years and had lived very frugally (would you believe a $900/month 1-bedroom apartment in manhattan two blocks east of union sq?), saving my money to one day pursue a long-held dream. I said to her, “I can buy you a house with cash today or I can start a business and, most likely, lose everything and have to start all over again.”
(This was my own version of David Einhorn’s memorable ‘Greenlight moment’ as recounted in his “Fooling Some of the People All of the Time.”)
She assented and not too many weeks later I walked away from my steadily ascending career and Puppetmaster Trading was formed. I was then in a similar circumstance to what my erstwhile pen-pal Sean is in today.
Around the time that I had this email exchange, I was being forced to face the fact that Puppetmaster Trading was in just such an untenable position as I’d described.
Someday I might write a post-mortem along the lines of the courageous and revealing post Roger Ehrenberg wrote describing the errors he’d made in one of his startups. But today isn’t that day; I need some distance and perspective to adequately compose my thoughts and identify the key errors I’ve made along the way.
So, to Sean and others like him, view this as a cautionary tale. Don’t view it as ‘proof’ that starting your company is a bad idea. Even given constraints like Sean‘s, I’m 100% certain that success was possible but for a few costly errors of judgment I personally made. After the first year and a half, our trading returns were always positive. In 2008 we had a real blowout year which could have been a game-changer had I not elected to pursue an ill-fated partnership (which hinted beguilingly at an outright sale) rather than sticking to what was working. There were other mistakes, too – some of them possibly worse. Interestingly, all of them were about running a business and not about algorithmic trading per se.
Selecting a business model and focus, funding issues, partnership dynamics, effective team-building and the like are where the game is won or lost.
the funny business (models) of algorithmic trading
As far as business models go, algorithmic trading can be taken in quite a few directions, the simplest of which is proprietary trading which is where we ultimately settled. If you’re building a platform you can try to be a product company, but then I don’t think you’d really qualify as an algo-trading concern. One can also form one of many varieties of funds or advisories to bring in external funding and all of these have their strengths and drawbacks. And all require the track record, marketing savvy and connections to bring in the commitments. We’ve looked at almost all of these options and pursued a few.
If you’re building your own platform with the intent of trading it, it’s a bit of a funny situation, because no-one wants to bear the cost of building a system you won’t sell. Buying systems and then integrating them such that they’re practically usable is such an expensive proposition that one is essentially forced to bring in external money unless they happen to have a few spare millions of dollars lying about that they don’t mind spending. Actually, in retrospect, this is nearly as true if you’re building instead of buying.
Perhaps the most interesting models that we explored were those in which algorithms backed structured products or ETF-like vehicles. I think there will be many such products in the future with good reason. But to do this, you need to partner with a bigger financial firm. Here, again, you need connections (and probably will be better served by a firm name a bit more sober than our own!) and at least some heft of your own as established investment houses aren’t in the business of working with the proverbial two guys in a garage.
All of these are viable models, and all present unique challenges and opportunities. The bottom-line is that to startup successfully you need to select one and then either obtain funding early on or you need to be lucky *and* commit no errors.
to build or buy…
As for the platform we built, Stratbox, I can only view it as a success – many tens of thousands of trades have passed through it and only once, very early on in (I think) december’05 (before it had even a rudimentary GUI), did we lose any money from it on account of a coding error. Although I haven’t looked carefully at algo platforms in years, I’m told it has features that even well-established companies haven’t put into their commercial products and there’s no doubt that having full source code enables degrees of freedom that are impossible with off-the-shelf products.
The fact that Stratbox isn’t a commercial product has real drawbacks, especially in terms of the ‘fit and finish’ one expects from established software. But it also brings considerable benefits in that you can really drive development based on immediate needs. In very short time frames, you can build the 90% of functionality that you need *now*. It’s just not possible for an established vendor to implement, test, and roll-out new features with the requisite solidity and 100% finish anywhere near as fast as can an ‘agile’ team with skin (and maybe an organ or two) in the game. Thus, if I were to start all over again, while I would look at the various vendor offerings (and might well change my mind based on that review), I’m still inclined to think that I’d continue to “roll my own”.
the evolution will be blogged
I started this blog as a means of composing my thoughts and sharing my ‘algorithmic trading experiences’ and in that light it’s been a quiet success. Although it has been a minor time- and cash-sink, I enjoy it and have benefited from the people I’ve met through its pages. I also always view writing as its own reward. I send a sincere “thank you” to all who have read and all who have shared their own insights and experiences. At some point – not too soon – I may try my hand at a constructive post-mortem. In the meanwhile, I’ll continue as I have and write when I have something to say. The longer-term fate of the blog remains to be seen and will likely depend on what I end up doing next.