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Trend Alphability

Published in Automated Trader Magazine Issue 11 Q4 2008

Automated Trader’s proprietary tradability metrics are environmental statistics intended to assist those building trading models/systems in determining which markets and timeframes are most favourably responsive to which generic types of model.

Trend Alphability

The Alphability stats for determining the 'trend friendliness' of markets shown here are based upon determining the amount of noise around a hypothetical trend. The simplest variant of Trend Alphability depicted here consists of the R2 (coefficient of determination) of a linear regression line plotted through the data points between the bars on which the low and high of a trading session were made (or the reverse if the high was made first). The calculation is based on the mid point of price bars in a variety of time frames. Multiplying this daily Alphability metric by the high/low range for the day (expressed as a percentage change) gives a ratio of 'trendiness' to the maximum available reward.

Reversal Alphability

Reversal Alphability follows similar general principles to Trend Alphability in that it provides a metric for the ease or difficulty of capturing a hypothetically optimal alpha. As the name implies, the differences lie in the generic types of model used. The variant of Reversal Alphability shown here is based upon two very simple reversal patterns, the short entry version of which is illustrated in Figure 1. For a short position the reversal entry logic is a bar (Bar 3) with a mid value greater than the preceding and succeeding bars (vice versa for a long entry).

To calculate the metric, the number of reversals in a day are calculated and divided into the sum of the percentage change of the moves from each reversal to the next. (Trend and Reversal Alphability are not necessarily mutually exclusive; it is perfectly possible for an instrument to have simultaneous high/low scores for both.)

 Figure 1: Peak Reversal (short entry)
Figure 1: Peak Reversal (short entry)

Score significance

Trend Alphability:

Stocks and stock index futures - above 2 extremely benign, 1-2 acceptable, below 1 (and especially below 0.5) adverse. Commensurate categories for bond futures are typically a third of these values.

Reversal Alphability:

Stocks and stock index futures - above 0.4 extremely benign, 0.3-0.4 acceptable, below 0.3 (and especially 0.2) adverse. Commensurate categories for bond futures are typically a third of these values.

For more information on Alphability, please see page 56 of the Q3 2007 edition of Automated Trader or visit http://www.automatedtrader.net/Alphability.xhtm

Figure 2: Daily Trend Alphability - top five Dow stocks (click for a larger view)

Ouch. The thrills and spills in AIG's Trend Alphability score need little explanation. Citi may appear to be flatlining in August, but it isn't. That's just the scaling effect of AIG's antics in September.

Figure 3: Daily Trend Alphability - bottom five Dow stocks (click for a larger view)

It's nice to know that in these troubled times there are some things you can still rely on - in this case Johnson & Johnson's inability to generate a tradable trend worth a damn. J & J may appear to be flatlining in August, because err well, it is.

Figure 4: Daily Trend Alphability - stock index futures (click for a larger view)

In the Q3 issue of Automated Trader, the Trend Alphability of stock index futures was decidedly muted, with all three futures only exceeding a score of 2.5 on one occasion. However, this time…

Figure 5: Daily Trend Alphability - bond futures (click for a larger view)

Apart from T-Bonds, bond futures were remarkably restrained. After some moments of excitement in Q3, the Long Gilt happily drifted back in the rankings in Q4.

Figure 6: Daily Reversal Alphability - top five Dow stocks (click for a larger view)

Intriguingly, AIG's Reversal Alphability took off more than a month earlier than its Trend Alphability; on two occasions in Q4 exceeding a score of 25. Again, the main observation relates to perspective; in Q3 no stock exceeded a score of 3 on even a single day - in Q4 the top three stocks had averages above 2.5.

Figure 7: Daily Reversal Alphability - bottom five Dow stocks (click for a larger view)

And you thought AIG was big news? When it came to Reversal Alphability in Q4, Johnson & Johnson managed to lose the bottom slot to 3M - a remarkable achievement. How much deader than dead can you be? Yet even here the average scores were nearly double those achieved in Q3. No wonder some of our stat arb readers think happy days are here again.

Figure 8: Daily Reversal Alphability - stock index futures (click for a larger view)

Yet again, Q3 looks like it was the proverbial lull before the storm; all stock index futures pretty much doubled their Reversal Alphability scores in Q4, with the FTSE future particularly rampant.

Figure 9: Daily Reversal Alphability - bond futures (click for a larger view)

In stark contrast to its Trend Alphability, the Long Gilt was almost animated in Q4, hitting a record 0.48 on September 1st. However, T-Bonds were again the most amenable to reversal trading overall.