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

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13 Risk and Drawdowns

By Hammad Khan

Risk can be defined in various ways. Measurement of risk of an alpha can simply be done by the level of volatility of its returns and the expected value at risk (which is a measure of maximum potential loss the alpha can incur given a statistical confidence level). Risk can be measured with certainty after the fact. But risk can be anticipated for an alpha with some simple techniques.

  • Position concentration in a particular security or a group of securities. For example, in equities, if an alpha takes too many positions in a particular security or a particular sector or industry, we can anticipate that the alpha is taking a high risk if something systematic happens to that security or group of securities. Similarly, in futures, if there are too many positions taken in commodities or bonds or equity indices, there is a systematic risk that an alpha is taking. Such risk can be anticipated by knowing how much exposures an alpha is taking in such positions.
  • Some alphas and alpha techniques are very commonly known and are used by many quantitative researchers and portfolio managers around the world. Such alphas – let’s call them factors – become a common source of risk because of a lot of money worldwide is riding on them. If performance in such factors degrades, funds may start flowing out of portfolios that are using them, which may cause further degradation in their performance. Any exposures to such factors can be measured by the position ...

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