How Math Makes Billions Every Day: Inside the World of Quantitative Finance
As of late at UC Berkeley, there has been a buzz all about a specific industry, especially amongst computer science students at the University. Many students, including myself, keep talking about wanting to be a “Quant”; but to many unfamiliar with the term, it holds little meaning.
Quantitative Finance, or “Quant” for short, is a field dedicated to using mathematics, probability, and algorithms to decipher patterns among the seemingly random world of finance. See the stock market: as much as we would all like to believe it is predictable, it is best approximated by random movements. This might explain why people who are trying to day trade stocks may have winnings no better than that of a gambler at a casino. However, a select few groups of investors realized that if you can accurately model movements of the markets and find hidden opportunities, you can profit off of this seemingly random behavior.
There are a variety of ways to do so, ranging from options in investing to employing a formula known as the Black-Scholes Equation (see video below):
But far and away, the most common role that Quant companies play in the modern day is that of a Market Maker. But what is a market maker?
Let’s say you were emptying out your house and found an old chair sitting in the garage. It’s still in decent condition so you figure you’ll go ahead and try to sell it. You could try to find someone to sell it to yourself, going door to door and offering up your chair to all of your neighbors— but that would be incredibly time and energy consuming. Even after all of your hard work, how would you know that you’re getting the best deal for your chair? And let’s say it wasn’t just you who had chairs to sell, but rather everyone who has ever wanted to sell a copy of the same chair. Wouldn’t it be helpful to have a common price to sell the chair at, and a place where you could instantly get rid of it?
Welcome Market Makers, the people who set up ‘markets’ for you to trade on, and now you have a place to sell your chair (Note: In reality, these markets are more centered around financial products such as options, but for the sake of this explanation we will stick with our analogy of chairs). Market makers create a ‘buy’ and ‘sell’ price for that chair, where the ‘buy’ price is always above or equal to the ‘sell’ price, so if you were to buy a chair and then sell it, you would lose a little bit of money.
The Market Maker promises you that if you want to sell your chair on their market that you will instantly be paid for it, so you don’t need to hunt down a neighbor to buy it. In essence, they provide the market with liquidity, a finance term for the ability to convert assets into cash. The job of quants working in market making is to determine what these buy and sell ‘strike prices’ should be to offer to the public. The Market Maker makes money on the ‘spread’ of these prices, or the delta between the two. For every chair sold to the market maker at $50 and bought at $55, the company pockets the $5.
But what does it take to become a “Quant”? Well as someone fresh off of failing at the process of becoming one, I feel qualified to tell you all about it. You don’t need to have mastered every level of Mathematics and don’t need to know complex Calculus to become a quantitative trader or algorithm developer. What is much more important is the ability to recognize opportunities to win— think games like poker or blackjack where you as the player have to keep track of some basic probabilities and odds to guide your judgment. I would firmly suggest studying Game Theory and fundamental Statistics (especially Expected Value). Knowing how to find the Expected Value of a scenario is the best tool out there for guiding smart financial decisions, and companies looking for talent are more than aware of that. In one of my final rounds for one of the largest hedge funds in the world, my interviewer simply walked into the room, pointed out the window, and asked me to find the distance between myself and a well known landmark (hint: it’s green and really tall).
These tests serve to analyze your ability to deduce mathematical information from everyday situations, and help demonstrate to the company that you are capable of making rational decisions even under pressure— there is a reason that quantitative traders have earned the nickname of “The Rocket Scientists of Wall Street”.
Now that you know about the industry, maybe you feel more compelled to apply, maybe you feel less compelled to— either way I hope you had a good time learning about something I’m passionate about!
