1-27. Alpha Factors

It’s common for researchers to normalize alpha factors by subtracting the mean and dividing by the standard deviation. We can also refer to this process as Z-scoring because the result is a Z-score. Z-scoring helps to standardize the data, so that it has a consistent range and distribution. This makes it easier to compare and … Read more

Ranking is a broadly useful method in statistics to make calculations more robust and less sensitive to noise. So, how do we use ranking here? If we have just two stocks in our portfolio, we would sort them by the office signal in descending order. So, for instance, let’s say we had a Raw Alpha … Read more

You may notice, that if the amount we invest in each stock of our portfolio is tied to the Alpha value that we get from daily data, then we would be constantly buying and selling every day in order to follow the signal faithfully. In other words, as the Alpha vector changes every day, we’d … Read more

So now that we’ve controlled for market risk, how can we control sector risk at this point. We often want our alpha factor to be sector neutral so that it’s not exposed to overall movements within a sector and this means that we want our short weights in the sector to be equal in magnitude … Read more

Okay. Let’s say we’ve read a paper, extracted some ideas, and have come up with an Alpha factor. Now, let’s talk about some of the common early transformations we might do to that factor in order to move it closer towards our goal. A vector of numbers that represents the weights we’d use to create … Read more

You may be wondering how to come up with alpha factors and trading strategies. Some sources of inspiration, maybe reading financial news, observing the markets for curious behavior, studying the methods of famous investors both discretionary and want or talking to industry practitioners. We’ll explore academic research papers as a source for alpha factor ideas … Read more

Another thing to remember, is that journals themselves impose their own editorial influence on papers too. They look for papers of certain types. They ask for papers to be structured in certain ways. They impose word counts and style guides. Often within a field, certain journals are known to be the most competitive to get … Read more

Let’s talk about the structure. Do you remember grade school science fairs and learning about the scientific method? Well guess what, what you learned actually applies to the real world. Papers are actually structured with title, abstract, methods, results, conclusions, and discussion sections. Let’s start at the beginning. The very first thing that you’ll read … Read more

Well, hello there. Thanks for joining me. I’m just going to pop in here and share some thoughts about reading research papers. I remember when I got started doing academic work, reading a research paper felt like a daunting task. I understood that reading a research paper meant sitting down with a cup of tea … Read more

Note that the word alpha is used to mean different things within the world of finance. In the context of factor models, we’ll refer to an alpha model as an algorithm that transforms input data into a list of numbers, one number for each stock under consideration per time step. A higher positive number means … Read more

Congratulations on making it through this lesson. We reviewed some foundational building blocks that you will see again and use when we translate academic papers into alpha ideas and then implement those ideas in code. But let’s just remember that, even after testing, if your alphas look promising, this is really only the first stage … Read more

So far, we’ve been looking at simple individual alpha factors. But there are times when we can create factors that are conditioned on another factor. We can create a conditional factor by multiplying two factors together. For example, if factor A gives an alpha value for a single stock, and factor B gives a different … Read more

In some alpha factor papers that we’ll discuss in the next lesson, the academic research discusses findings that are specific to one direction or one tail end of a particular attribute. A practitioner’s approach is to think about extending the interpretation of the academic conclusion, so that it can be more readily applied to general … Read more

Recall that we prefer to control for risk within the Alpha factors, rather than waiting for their risk model optimizer to do it completely for us. This is why we make the Alpha vector dollar neutral and often also sector neutral. The reason we wish to control for risk early on within the Alpha vector … Read more

As practitioners, we were reading academic research papers for insights. So, it’s helpful to know how academic papers and practitioners view quantiles differently. Academic papers tend to take raw alpha signals, which are not ranked, and split them into quantiles only. Their analysis usually focuses on the tails. That is, the highest and lowest quantiles. … Read more

Here’s an example of an ideal Alpha factors quintile performance. The fifth group containing the highest Alpha values would ideally give the highest returns. There would also ideally be a smooth progression, down the fourth, third, second, and first groups. That is the fourth group would have lower returns than the fifth group, but higher … Read more

We saw earlier that the rank IC can tell us overall how well an Alpha vector’s predictions align with the subsequent stock returns for the next period. You may be wondering if it’s possible to drill down deeper to look at the Alpha values assigned each stock to see which subset of stocks actually contribute … Read more

Another way to measure turnover, is called the factor rank autocorrelation. The factor rank autocorrelation is close to one, when the ranking of stocks doesn’t change much from day to day. To give you an illustration, let’s imagine our universe consists of just two stocks, apple and alphabet. If over several days, the rank of … Read more

Since liquidity and transaction costs are dependent upon market conditions at the time of a trade, it’s difficult to simulate actual transaction costs when evaluating an Alpha factor. So a useful proxy for these real-world constraints is to measure turnover. Generally, factors that are updated quarterly such as fundamental factors, have lower turnover compared to … Read more

Another real-world constraint is the total transaction cost, the implicit and explicit costs of making trades. Transaction costs add up and are often a substantial contributor to the success or lack of success of a trading strategy. Most people immediately think of commissions, the explicit cost, as the transaction cost. However, for an institutional market … Read more