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

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5 How to Develop an Alpha. I: Logic with an Example

By Pankaj Bakliwal

Alphas are mathematical models to predict the future price movements of various financial instruments.

Alpha Logic →Information in the Form of Data → Idea → Mathematical Expression → Apply Operations → Final Robust Alpha → Translate into Positions in Financial Instrument → Check Historical PnL, Other Performance Measurements (Information Ratio, Turnover, Drawdowns, etc.)

The goal is to make profits while minimizing risk, and to develop a mathematical predictive formula by using appropriate information. In order to convert this mathematical formula into stock positions, this formula should have three types of values:

Positive → long position

Negative → Short position

0 → No position

Also, the magnitude of the value derived for each stock from the mathematical formula should be proportional to the dollar amount of the position.

Let’s use an example.

STEP 1 → COLLECT INFORMATION

Consider two stocks from the technology sector: Google and Apple. The information is available in the form of daily historical prices of these two stocks. Let’s say that we also have information about an upcoming event that would affect the technology companies either in a positive or a negative manner. The second statement has no directional information.

STEP 2 → COME UP WITH AN IDEA

Once we have all the information available, the next step is to come up with a sensible idea. Let’s say that based on the historical prices, the ...

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