What Is Alpha and How to Get It: A Practical Guide for Traders and Investors

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How to Achieve Alpha in Your Trading Strategy

If you are an investor or a trader, you probably have heard of the term alpha. But what does it mean and why is it important for your trading strategy? In this blog post, we will explain what alpha is, how it is calculated, and how you can achieve it in your trading strategy.

What Is Alpha?

Alpha (α) is a term used in investing to describe an investment strategy’s ability to beat the market, or its “edge.” Alpha is thus also often referred to as “excess return” or the “abnormal rate of return” in relation to a benchmark, when adjusted for risk¹.

Alpha is often used in conjunction with beta (β), which measures the broad market’s overall volatility or risk, known as systematic market risk. Alpha is used in finance as a measure of performance, indicating when a strategy, trader, or portfolio manager has managed to beat the market return or other benchmark over some period. Alpha, often considered the active return on an investment, gauges the performance of an investment against a market index or benchmark that is considered to represent the market’s movement as a whole. The excess return of an investment relative to the return of a benchmark index is the investment’s alpha. Alpha may be positive or negative and is the result of active investing. Beta, on the other hand, can be earned through passive index investing¹.

How Is Alpha Calculated?

Alpha is computed in relation to the capital asset pricing model (CAPM). The CAPM equation is used to identify the required return of an investment; it is often used to evaluate realized performance for a diversified portfolio. Because it’s assumed that the portfolio being evaluated is a diversified portfolio (meaning that the unsystematic risk has been eliminated), and because a diversified portfolio’s main source of risk is the market risk (or systematic risk), beta is an appropriate measure of that risk. Alpha is used to determine by how much the realized return of the portfolio varies from the required return, as determined by CAPM. The formula for alpha is expressed as follows²:

$$�={�}_{�}\text{–}[{�}_{�}+({�}_{�}\text{–}{�}_{�})�]$$

Where:

${�}_{�}$ = Realized return of portfolio

${�}_{�}$ = Market return

${�}_{�}$ = the risk-free rate

$�$ = the asset’s beta

How to Achieve Alpha in Your Trading Strategy?

Achieving alpha in your trading strategy means that you are able to generate returns that are higher than what the market or your benchmark offers, given the same level of risk. This implies that you have some kind of edge or advantage over other market participants, such as superior information, analysis, skills, or execution. Here are some possible ways to achieve alpha in your trading strategy:

• Use a quantitative approach: A quantitative approach involves using mathematical models, algorithms, and data analysis to identify patterns, trends, and anomalies in the market. By using a quantitative approach, you can potentially exploit market inefficiencies, arbitrage opportunities, and behavioral biases that other traders may overlook or ignore. A quantitative approach can also help you reduce emotional and cognitive biases that may affect your trading decisions, such as overconfidence, loss aversion, or confirmation bias³.
• Use a contrarian approach: A contrarian approach involves going against the prevailing market sentiment or opinion. By using a contrarian approach, you can potentially profit from market overreactions, corrections, and reversals that other traders may miss or avoid. A contrarian approach can also help you diversify your portfolio and reduce your correlation with the market⁴.
• Use a niche approach: A niche approach involves focusing on a specific market segment, sector, or asset class that has less competition, more inefficiencies, or more growth potential than the broader market. By using a niche approach, you can potentially gain an edge over other traders who may have less knowledge, experience, or access to that market segment, sector, or asset class. A niche approach can also help you specialize and develop your expertise in a particular area of the market⁵.

Conclusion

Alpha is a measure of the excess return or the abnormal rate of return that an investment strategy generates over a benchmark, when adjusted for risk. Alpha is a key indicator of the performance and the value added by a strategy, trader, or portfolio manager. Achieving alpha in your trading strategy requires having an edge or an advantage over other market participants, such as superior information, analysis, skills, or execution. Some possible ways to achieve alpha in your trading strategy are using a quantitative approach, a contrarian approach, or a niche approach.

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