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A nice presentation Anthony, thank you for sharing this with us. For a
novice in this type of TA it will take me a few days to fully understand
what you are doing. I never used alpha and beta before.
Do you always use a standard index, because it may more closely reflect
trader sentiment, or can custom indices or composites play a role?
What would be the typical trade-duration?
How do you time you entries? A second system?
many thanks for your post,
herman.
-----Original Message-----
From: Anthony Faragasso [mailto:ajf1111@xxxxxxxx]
Sent: Friday, September 19, 2003 7:32 PM
To: amibroker@xxxxxxxxxxxxxxx
Cc: advenosa@xxxxxxxxxxxx; Al; Herman van den Bergen; Steve; Steve
Sidley
Subject: [amibroker] Alpha-Beta Trading System
Alpha-Beta Trading System (Part I): Trading With A Stock's Alpha
Relative strength trading can be one of the ways to trade the market for
short-term gains. Basically, the concept of relative strength trading
involves picking stocks that will perform better than the general market as
represented by some Index. Technically a market Index is just a basket of
component stocks, but in reality it is more than the sum of its parts. For
market players, it is a psychological reference, and therefore has a
feedback effect. i.e. while prices affect the Index, the Index also affects
prices. This enhances the value of relative strength trading. The two main
calculations required for trading the relative strength of a stock are its
Beta and Alpha.
The Beta of a stock is defined as the slope of a regression line in a
scatter graph of paired data points representing percentage changes of an
Index and the corresponding change in the price of a stock (See Fig. 1). The
Alpha is the point where this regression line cuts the Y-axis. A stock's
Beta can be described as that part of a stock's movement that is influenced
by the Index. And a stock's Alpha can be regarded as that part of a stock's
movement that is independent of the Index's movement. In practical terms,
examples of stocks increasing in Alpha could be those with take-over
rumours, under strong syndicate manipulation, or having strong expectations
of good results, i.e. factors which make them move more and more
independently off the Index.
Fig. 1. The Alpha and Beta of a stock, where Alpha is the vertical intercept
and Beta is the slope of the best fit line.
Using the Beta to trade is quite common, but not so common is using the
Alpha. Actually stock picking by Alpha is a much more rewarding and less
dangerous task than stock picking by Beta.
In our method, we design Alpha for trading very short term i.e. 5 days,
screening with volatility and volume condition indicators. The number of
data points used to calculate Alpha is first aggregated in clusters to
produce points for percentage changes over a certain number of days. This
results in a very sparse data set, and the regression line is "forced" to
fit these few number of points. The under-fitting is deliberate although
unconventional by statistical theory standards.
To narrow down the choice, step-by-step filtering is next applied. You could
first filter by volatility which can be represented by Average True Range or
some other volatility indicator of your choice. The second filter could be
some sort of Buy*Volume condition, for example:
H>HY1*V>VY1*L>LY1=1
which means: High of today>High of Yesterday AND Low of Today>Low of
Yesterday AND Volume of Today>Volume of Yesterday. A third filter condition
could be that today's Close should be greater than yesterday's Close, i.e.,
C>CY1
It is quite up to the individual to specify the conditions according to his
risk profile and his trading style. A totally mechanical approach would not
be successful. For example on days that the market was down, filtering with
a Buy*Volume condition may not be appropriate. On days that the market was
up, C>CY1 should be part of your filter, the stocks to be selected should
have moved up with the market with the majority of stocks. And after
filtering you could discard any stocks with negligible Volume from your
list.
Some guidelines for the use of Alpha and Beta in trading are given below:
1 For very short-term trading, stocks with Beta >1.5 can be regarded as high
Beta stocks.
2.Absolute values of Alpha depend on time span of data, and period over
which the change is recorded. What is more relevant is the change in Alpha.
3. A stock with high Beta moves up fast when the Index goes up, but also
moves down fast with the Index, unless it has a high Alpha value in which
case, the Alpha value acts as a support.
4. A stock with high Alpha, but not necessarily high Beta, can move up fast
when the Index moves up, if the circumstances for the high Alpha are still
present or have increased in influence. This can be depicted as a moving up
of the whole regression line, resulting in a higher point of intercept with
the Y-axis.
5. Therefore the way to select stocks is to look for changes in Alpha or
Beta rather than values of Alpha and Beta. The absolute Alpha and Beta
values only show the status quo. To add an element of prediction, the change
in Alpha would be more useful.
6. It is better to choose stocks with increasing Alpha rather than
increasing Beta. High Beta stocks with low Alpha values require great
alertness and usually intra-day trading strategies.
7. The most potentially rewarding stocks are those that have a high Beta as
well as a high Alpha; with the added conditions that these values have not
peaked,or are already on the way down. This can be confirmed by graphing the
Alpha and Beta values.
8. When Alpha and Beta values are graphed, and put on a split screen
together with the stock's price line chart, they are seen to be in waves
each having a span of between 3-5 days. These waves reflect the inevitable
profit taking. But trends and patterns in the waves can also be seen, and
these can be analysed using traditional technical analysis concepts of
trend, support, resistance and divergence. (See Fig. 2)
Fig. 2. The Alpha and Beta values with price charts of a stock and an index.
The thicker line is the Alpha.
9. Generally, a stock is "in play" when the amplitude of its alpha waves are
getting bigger while its alpha value is also trending up.
10. Trading short-term with Alpha assumes a trending and reasonably volatile
market. In a sideway market, Alpha would not be useful. The determination of
market direction and whether it is in a trending stage can be by means of
indicators like the ADX and Moving Averages.
11. In a down-trending market, you could either buy stocks with consistently
high Alphas for the market's rebound, or,if short-selling is allowed, choose
stocks with high Beta and low Alpha.
12. By scanning several markets and seeing which have more stocks with Alpha
values at the higher end of the market range, it is possible to select which
market to participate in.(A frequency histogram of markets will show which
side the values of Alpha are skewed towards).
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