Friday, March 30, 2012

Using Perturbation Theory to Build Trading Models and Systems

I have recently finished reading Mr. Brian Greene’s book, The Elegant Universe. It is a fascinating book about string theory. One of the concepts Mr. Greene discusses is how physicists use perturbation theory to advance their knowledge and theoretical ideas.

Mr. Greene says that the mathematical framework of string theory is so complicated that physicists have to use approximate solutions and calculations, while initially ignoring some details. Later, these solutions and calculations are further refined as more details and knowledge are systematically included. The perturbative process can also be used to build trading models.

I had no idea of perturbation theory before reading this book, but I now feel it describes the process of how I created trading models. The stock market is also complicated and difficult to understand (probably more so then string theory). Initially, I began to systematically organize some variables, ideas, and concepts, while leaving others out. I began to create some general ideas, theories, and approximate solutions to trading. Later, with further testing, experimentation, and pain (the great teacher), I was able to increase my knowledge of how the market works, and I began to systematically include more details and concepts. This led to further refined ideas and theories which eventually became my trading models.

But here is some advice and a word of warning to traders out there—the key is to use a perturbative approach up to a point. The irony is that the more variables added to “refine” and “improve” a model, the more likely it is that the model will breakdown.


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