Quality Money Management : Process Engineering and Best Practices for Systematic Trading and Investment

principal component analysis to understand the system. Reverse engineering is a systematic

approach for analyzing the design of existing trading/investment systems.

Most trading and investment firms are highly secretive, protecting proprietary meth-

ods. Even identifying the best competitors can be difficult. Nonetheless, information

should be pursued. (Although it is tempting to use illegal or unethical ways of gaining an

advantage, quality and its customer-focus prohibit such short-term thinking.^6 ) Consider

the following ethical uses involved in reverse engineering:

● Do not reverse engineer components of a trading system if a licensing contract

prohibits it.

● Remember to perform reverse engineering using only information that is not propri-

etary to the firm you are scoping.

If you intend to perform reverse engineering, be sure that:

● The firm does not have access to proprietary information.

● The firm does not obtain information from disgruntled employees who work or very

recently worked for the competing firm and/or who are under contractual obligation

to refrain from releasing proprietary information. (Employees at firms that use quality

money management should not be disgruntled!)

● The firm maintains complete documentation of each component it reverse engineers

so there is a record that will stand as proof in court that it performed its reverse

engineering lawfully.

Reverse engineering initiates the redesign process, wherein a product is observed,

tracked, analyzed, and tested in terms of its performance characteristics. The intent of

the reverse engineering process is to fully understand and model the current instance of a

trading strategy in order to compress the new product development time.

9.3. STEP 2, LOOP 2: Research New Methods

Because the best practice is in fact unknown (and theoretically unknowable), benchmark-

ing is really a misnomer. We are not simply copying a competitor ’ s system deemed to be

“ best practice ” and implementing it in-house. Product teams use a benchmark as a refer-

ence point against which to compare its own proprietary calculations. Without a reference

point, the team cannot know if its calculations are in the top rank of its peer group or not.

Over the course of their research, financial engineers investigate mathematical mod-

els and logical constructs according to best practices, taking notes, writing up, and cri-

tiquing what they find, comparing alternative methods in an attempt to best describe the

interaction between data and the desired outcome. Successful researchers calibrate their

methods by first applying them using known inputs and outputs and documenting the

results before applying the methods to unknown inputs. In practice, the accumulation of

evidence for or against any particular quantitative method involves a planned research

design for the collection of empirical data. The best method is algorithm benchmarking,

which will increase the probability of success.

We recommend the team keeps research independent of data and testing (our methodol-

ogy forces this separation). This will help avoid, among other things, spurious correlations.

Best practice also requires that teams separate the process of specifying the formulas

9.3. STEP 2, LOOP 2: RESEARCH NEW METHODS 101