Alpha profiling
is an application of
machine learning
Machine learning (ML) is a field of inquiry devoted to understanding and building methods that 'learn', that is, methods that leverage data to improve performance on some set of tasks. It is seen as a part of artificial intelligence.
Machine ...
to optimize the execution of large orders in financial markets by means of
algorithmic trading
Algorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of ...
. The purpose is to select an execution schedule that minimizes the expected
implementation shortfall
In financial markets, implementation shortfall is the difference between the decision price and the final execution price (including commissions, taxes, etc.) for a trade. This is also known as the " slippage". Agency trading is largely concerned ...
, or more generally, ensures compliance with a
best execution
Best execution refers to the duty of an investment services firm (such as a stock broker) executing orders on behalf of customers to ensure the best execution possible for their customers' orders. Some of the factors the broker must consider when ...
mandate.
Alpha profiling models learn statistically-significant patterns in the execution of orders from a particular trading strategy or portfolio manager and leverages these patterns to associate an optimal execution schedule to new orders. In this sense, it is an application of
statistical arbitrage In finance, statistical arbitrage (often abbreviated as ''Stat Arb'' or ''StatArb'') is a class of short-term financial trading strategies that employ mean reversion models involving broadly diversified portfolios of securities (hundreds to thousan ...
to best execution. For example, a
portfolio manager A portfolio manager (PM) is a professional responsible for making investment decisions and carrying out investment activities on behalf of vested individuals or institutions. Clients invest their money into the PM's investment policy for future grow ...
specialized in
value investing
Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...
may have a
behavioral
Behavior (American English) or behaviour (British English) is the range of actions and mannerisms made by individuals, organisms, systems or artificial entities in some environment. These systems can include other systems or organisms as well ...
bias to place orders to buy while an asset is still declining in value. In this case, a slow or back-loaded execution schedule would provide better execution results than an urgent one. But this same portfolio manager will occasionally place an order after the asset price has already begun to rise in which case it should best be handled with urgency; this example illustrates the fact that Alpha Profiling must combine public information such as market data with private information including as the identity of the portfolio manager and the size and origin of the order, to identify the optimal execution schedule.
Market Impact
Large block orders can generally not be executed immediately because there is no available counterparty with the same size. Instead, they must be sliced into smaller pieces which are sent to the market over time. Each slice has some impact on the price, so on average the realized price for a buy order will be higher than at the time of the decision, or less for a sell order. The
implementation shortfall
In financial markets, implementation shortfall is the difference between the decision price and the final execution price (including commissions, taxes, etc.) for a trade. This is also known as the " slippage". Agency trading is largely concerned ...
is the difference between the price at the time of the decision and the average expected price to be paid for executing the block, and is usually expressed in basis points as follows.
:
Alpha Profile
The alpha profile of an order is the expected impact-free price conditioned on the order and the state of the market, form the decision time to the required completion time. In other words, it is the price that one expects for the security would have over the execution horizon if the order were not executed. To estimate the cost of an execution strategy, market impact must be added to the impact-free price.
It is well worth stressing that attempts to estimate the cost of alternative schedules without impact adjustments are counter-productive: high urgency strategies would capture more liquidity near the decision time and therefore would always be preferred if one did not account for their impact. In fact, front-loaded execution schedules have a higher average impact cost.
Estimating an alpha profile
One way to compute an alpha profile is to use a
classification Classification is a process related to categorization, the process in which ideas and objects are recognized, differentiated and understood.
Classification is the grouping of related facts into classes.
It may also refer to:
Business, organizat ...
technique such as
Naive Bayes
In statistics, naive Bayes classifiers are a family of simple "Probabilistic classification, probabilistic classifiers" based on applying Bayes' theorem with strong (naive) statistical independence, independence assumptions between the features (s ...
: find in the historical record a collection of orders with similar features, compute the impact-free price for each case, and take the simple average return from trade start over the next few days. This method is
robust
Robustness is the property of being strong and healthy in constitution. When it is transposed into a system, it refers to the ability of tolerating perturbations that might affect the system’s functional body. In the same line ''robustness'' ca ...
and transparent: each order is attached to a class of orders that share specific features that can be shown to the user as part of an explanation for the proposed optimal decision. However, an alpha profiling model based on classifying trades by similarity has limited
generalization
A generalization is a form of abstraction whereby common properties of specific instances are formulated as general concepts or claims. Generalizations posit the existence of a domain or set of elements, as well as one or more common characteri ...
power. New orders do not always behave in the same way as other orders with similar features behaved in the past. A more accurate estimation of alpha profiles can be accomplished using
Machine Learning
Machine learning (ML) is a field of inquiry devoted to understanding and building methods that 'learn', that is, methods that leverage data to improve performance on some set of tasks. It is seen as a part of artificial intelligence.
Machine ...
(ML) methods to learn the probabilities of future price scenarios given the order and the state of the market. Alpha profiles are then computed as the statistical average of the security price under various scenarios, weighted by scenario probabilities.
Risk-adjusted Cost
Optimal execution is the problem of identifying the execution schedule that minimizes a risk-adjusted cost function, where the cost term is the expected effect of trading costs on the portfolio value and the risk term is a measure of the effect of trade execution on risk. It is difficult to attribute the effect of trade execution on portfolio returns, and even more difficult to attribute its effect on risk, so in practice an alternate specification is often used: cost is defined as the implementation shortfall and risk is taken to be the variance of the same quantity. While this specification is commonly used, it is important to be aware of two shortcomings. First, the implementation shortfall as just defined is only a measure of the cost to the portfolio if all orders are entirely filled as originally entered; if portfolio managers edit the size of orders or some orders are left incomplete,
opportunity cost
In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...
s must be considered. Second, execution risk as just defined is not directly related to portfolio risk and therefore has little practical value.
Optimal Execution Schedule
A method for deriving optimal execution schedules that minimize a risk-adjusted cost function was proposed by Bertsimas and Lo. Almgren and Chriss provided closed-form solutions of the basic risk-adjusted cost optimization problem with a linear impact model and trivial alpha profile. More recent solutions have been proposed based on a propagator model for market impact, but here again the alpha profile is assumed to be trivial. In practice, impact is non-linear and the optimal schedule is sensitive to the alpha profile. A
diffusion
Diffusion is the net movement of anything (for example, atoms, ions, molecules, energy) generally from a region of higher concentration to a region of lower concentration. Diffusion is driven by a gradient in Gibbs free energy or chemical p ...
model
yields a functional form of market impact including an estimate of the speed exponent at 0.25 (trading faster causes more impact). It is possible to derive optimal execution solutions numerically with non-trivial alpha profiles using such a functional form.
References
External links
Learning By Doing{Dead link, date=September 2019 , bot=InternetArchiveBot , fix-attempted=yes
Alpha Profiling
Mathematical finance
Investment