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Financial Engineering Or Quant Trading ?

If you are investing or trading in any form, you may have already heard the term “quant” which is a very common buzzword in the finance industry (see my article here).

What is exactly a quant?

A quant is a person who knows a lot about mathematics and tries to use that knowledge to make money in the financial market, Simple.

Of course, this can be done in many different ways; that is why quants need do specialize depending on which particular financial sector they want to work in.

They all have some knowledge in common, but at a certain point of their education, they need to know what path to follow.

Doctors have studied medicine. They know all about how the human body works, but after that, they become surgeons, dentists or cardiologists, etc.

Quants have all studied quant finance, but they then need to choose whether to become quant trader, developer, researcher, or some other specialization.

Every year, technology is implemented more extensively in finance, and new types of quant roles come up. Making a list of all every type of role is not possible.

However, we can still sort all of them into two different categories:

Financial Engineers and Quant Traders.

It is a pretty rough distinction, but before disagreeing, please read my article all the way to the end.Everything will make sense.

Financial Engineering:

If you ask them what do they do, they will give you an endless list of fascinating tasks that can all be summarized in a single sentence: they try to find the right price of financial products.

If you want to decide the price of an artisanal product, you just sum up the price of its materials, plus the number of hours to make it, add in fixed expenses and a profit margin and you have the final price.

Pricing a financial derivative, like an exotic option, for example, it is much more difficult than pricing any other physical object you can find in a supermarket.

It is so hard that to do their job that financial engineers have to move in a pretty funny world—one where the probability that things have to happen is different from the one we have here on the planet earth.

They live on a planet where everything occurs with some probability Q , which is different from the normal probability that the same event could have in our everyday world.

It sounds very weird, I know, but they are not crazy—and neither am I.

Financial products, in order to be priced, need to be mathematically “transported” in a world where everything happens with a different likelihood. It is just a mathematical trick. To explain it in detail would take far too much time.

“I want to give you just one little hint”

In the real world, where everything happens according to a probability P, you get financially compensated when you run a risk. If you buy something risky, for instance, with a high probability of losing your money, you will be compensated for your risk with a bigger return.

The world of Q, instead, is a pretty nasty world, because the probability of events is “adjusted” to remove your compensation for the risk you take.

I know you are thinking that this does not make a lot of mathematical sense. It is just a mathematical trick and the only way we have to price derivatives.

And,of course, the little “hint” above is not very quantitative and accurate, but if someone wants to know more, he can buy a book on measure theory and have fun. 😊

On planet Q, most of the math you learned in high school does not work at all—you have to re-learn how to do integration, differentiation, etc.

Calculus becomes stochastic calculus, which is much more difficult.

That is why financial engineers usually have big salaries—because their job is pretty difficult and they have to be pretty skilled to make it.

If you want to see something scary,have a look at some questions for any junior quant position in an investment bank in London. If you thought you were good at math, then you will quickly realize that you are not.

You might be surprised, but these people don’t really care about forecasting prices. They won’t tell you where the Dow Jones will trade tomorrow, because it’s really not their job.

They would instead know how to price any exotic derivative on it.

Quantitative Trader :

This category can be segmented into many more subcategories, but they all have something in common.

Like us, they live on planet earth—far away from the Q world where financial engineers are living.

To describe them—because there are far too many people calling themselves quants, instead of saying what they are—I want to start by telling you what they are not.

A quant trader is not someone who uses a cheap retail trading platform to back-test simple technical analysis patterns, like MT4. A quant trader is also not an options trader who knows how to use Excel and remembers some statistics from high school.

Let’s go a step further and describe their actual work.

Quant traders do a job that, although it is pretty complicated, it is possible to have a sense of it from outside.

They try to forecast the markets using a lot of different types of mathematics, which all have one thing in common: they are all very difficult.

They use past data to forecast future data—that is it. Whether they are working in portfolio management, risk forecasting or building a trading system, they primarily have to predict something.

They can use different approaches, time series analysis, statistical learning, game theory, but what they have in common is that they will disagree about the best way to go.