Alpha, Alpha Signals, and How They Relate to Trading Advantages
The financial markets are a capricious animal. It is well known that most investments made in stocks, forex, and so on are prone to the volatility of the larger ecosystem. Trader’s aren’t consigned to making investments on a whim and a prayer. Thanks to the magic of a little thing called math — statistical models specifically — it is possible to forecast market movements and analyse the strength of your portfolio or the conviction you may have on the movement of a particular stock/asset/currency/crypto-currency (within a certain degree of accuracy). Without getting too technical — here’s what Alpha is about — and why it’s so important to seek when looking for an advantage in anything you might trade.
What Is Alpha
Alpha is a metric used to gauge the outperformance of a trading portfolio over a normalised portfolio. It is one of modern portfolio theory’s statistical measures used to quantify the returns made from an investment against a benchmark. The better the alpha value, the better an investment performed against market indices.
A single integer value represents the metric. A positive alpha value indicates that the fund performed better than benchmarks, while a negative value denotes the opposite. So an alpha of 1 tells you that investment is doing 1% better than the benchmark value. An alpha of -2 on the other hands shows you’ve underperformed against the benchmark by 2%.
Ok — let’s pause there.
Sure, in this explanation of alpha we’re looking at “gauging the performance of a trading portfolio against a benchmark”. But Alpha can also be used to gauge the performance of “X” (where X represents the criteria/signal that you’ve identified or are looking at) against a benchmark as well.
For example, you may be considering price momentum or profitability. If you’re looking at profitability, you may, for example, say that the average market profitability for the sector you’re trading in is 1. Thus, if your selected stock has a profitability of 2 — then it’s an alpha signal that your selected stock is outperforming the market. Whether you purchase it or not is irrelevant, what’s important is that you’ve got an indication that this stock is better than others in the sector — because you’ve mathematically found a way to compare, and have removed your opinion or emotion from the equation.
How Is Alpha Generated
Alpha is one of the ways how investors can tell the quality of an investment manager, or with a combination of alpha signals, the quality and probabilistic movement of an investment vehicle relative to the market.
Consider a case in which an investment manager can generate an alpha of 1. That’s great, right? The money you’ve invested has generated a 1% better return than the projected standards. However, if your advisor charges a commission of 2% of the portfolio, then the investor makes a loss despite his portfolio having outperformed market benchmarks.
In the previous section, we’ve also looked at how an applied alpha signal may give you insight into the quality of an investment vehicle, or even an idea into the direction of movement for an investment vehicle.
With this understanding, here’s where it get’s very very interesting.
Hidden Alpha Signals & Competitive Advantages
Consider the amount of information that is created on the Internet each day. In 2016 the IDC estimated that approximately 44-Billion GB of data were uploaded to the internet every day. Every day. 44-Billion GB of data. This is an astounding number.
And it doesn’t include trending data (who’s doing what), or phone call data, or traffic data, or stock market data etc. etc. We could go on and on.
What’s exciting is that with all of the data that is generated, there are (or undoubtedly be) trends that statistical models could identify — theoretically allowing you (or computer programs) to make better decisions about the topic you are geared towards. In this case, investing.
In a relatively basic example, let’s say for example you were going to have a friendly bet against a friend about if Uber usage was going to go up this weekend based on weather. Silly to think — but let’s go with it for a second. Imagine if you could collect an alpha signal about the weather patterns while collecting an alpha signal about umbrella sales, and collecting sentiment data about if people thought it was going to be a rainy weekend (sentiment being views/attitudes about a particular topic). Would you not be in a far better position than your friend for making an informed decision?
Naturally, this seems a little unfair — especially if your friend was working with no data or insight at all.
And yet this is precisely what happens daily in market trading.
Given its importance, investment managers are constantly on the lookout for means to generate alpha for the funds they handle — and are constantly looking for alpha signals, and sentiment data to indicate if a particular stock, currency, or market is going to move in a certain direction.
Having alpha signals and sentiment data can facilitate a massive and seemingly “unfair” advantage.
Alpha Signals and Sentiment Data Approached in a New Way
Understanding alpha signals lead to the natural questions — How do I get involved? How do I generate my own? While questions of that nature are beyond the scope of this post — there are dozens of theories on how to execute various mathematical models, generate alpha signals and coordinate large amounts of data into computer algorithms — we’d like to simplify it, just a little bit.
As ZeroSum progresses with the volume of trades that happen over a given period (let’s say monthly) — the sentiment data that will be generated is poised to grow exponentially in a multitude of ways. Given the volume of individuals making decisions based on actual market conditions, currencies, or cryptocurrencies — anyone will be able to use the platform data as a source of anonymised alpha signals.
To further enhance the capability of collecting and leveraging sentiment data on standard market movements, as the platform expands its capacity to compete on anything that has a data feed — the capacity to seek alpha signals expands as well.
The seemingly “unfair” advantage now gains an entirely new capacity — allowing traders to have access trends and data in retail trading (on the ZeroSum platform) as they happen. Naturally, this is built within the ZFX ecosystem — as access to the Sentiment Engine is paid for with ZFX tokens, the currency of the ZeroSum platform. It’s a win-win situation — as the proceeds are distributed amongst users who contributed data to the Sentiment Engine.
With the importance of alpha signals as high as they are, we believe it’s a great addition to the standard insights available now.