Generating alpha is only one out of the three legs required for a complete trading strategy. The alphas generated need to be blended with the risk model and the transaction cost estimates in the optimizer in order to come up with the corresponding orders that need to be placed. An illustration of this process is presented below:
- For transaction costs, typically investors perform the following calculation:
Transaction costs = Trade Fees + Bid-Ask Spread Cost = x bp + Bid-Ask Spread / 2
where x is the trade fees imposed by the broker
- The risk model refers to the variance-covariance matrix of the stock returns
- Alphas refer to the blend of a number of standardized alphas, e.g. momentum variations, mean reversion variations, pairs trading, etc.
The optimizer in then performing the following operations (multi-objective optimization):
- Maximize alpha exposure
- Minimize transaction costs
- Minimize risk
Other objectives and constraints are typically included: neutralizing exposure to beta (for market neutral strategies) and setting caps for trade size, position size, industry exposure, country exposure, etc. We are planning to dig further into the optimization process in future posts.