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Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

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1 Introduction to Alpha Design

By Igor Tulchinsky

An alpha is a combination of mathematical expressions, computer source code, and configuration parameters that can be used, in combination with historical data, to make predictions about future movements of various financial instruments. An alpha is also a forecast of the return on each of the financial securities. An alpha is also a fundamentally based opinion. The three definitions are really equivalent. Alphas definitely exist, and we design and trade them. This is because even if markets are near-efficient, something has to make them so. Traders execute alpha signals, whether algorithmic, or fundamental. Such activity moves prices, pushing them towards efficiency point.

HOW ARE ALPHAS REPRESENTED?

An alpha can be represented as a matrix of securities and positions indexed by time. The value of the matrix corresponds to positions in that particular stock on that particular day. Positions in stock change daily; the daily changes are traded in the securities market. The alpha produces returns, and returns have variability. The ratio of return to standard deviation (variability) of the returns is the information ratio of the alpha. It so happens that the information ratio of the alpha is maximized when alpha stock positions are proportional to the forecasted return of that stock.

Expressions and Programs

Alphas can be represented by expressions consisting of variables or programs. Such expressions, or programs, are equivalent ...

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