The Process of Finding Formulaic Alphas

Finding formulaic alphas involves steps like data sourcing, feature computation, and generating alphas using evolutionary algorithms



2/16/20243 min read


Data Sourcing and Feature Computation

In the quest to find profitable trading patterns, one of the crucial steps is data sourcing and feature computation. This process involves gathering relevant data and calculating various features that can be used for analysis. The quality and accuracy of the data play a significant role in the success of the algorithm, as it forms the foundation for generating formulaic alphas.

When it comes to data sourcing, there are various options available. Traders can obtain data from financial databases, market data providers, or even scrape data from public sources. The choice of data source depends on the specific requirements and preferences of the trader. It is essential to ensure that the data is reliable, up-to-date, and covers the necessary time period for analysis.

Once the data is sourced, the next step is feature computation. Features are derived from the raw data and are used as inputs for the algorithm. These features can be simple calculations such as moving averages, standard deviations, or more complex indicators like relative strength index (RSI), stochastic oscillators, or Bollinger Bands. The selection of features depends on the trading strategy and the specific patterns the trader wants to capture.

Feature computation involves applying mathematical formulas and statistical calculations to the raw data. This process transforms the data into meaningful and actionable insights. It is crucial to choose the right set of features that have predictive power and can capture the desired trading patterns.

Generating Formulaic Alphas with Evolutionary Algorithms

Evolutionary algorithms, such as genetic programming, provide a powerful tool for generating formulaic alphas. These algorithms automate the search for profitable trading patterns by mimicking the process of natural selection and evolution.

The process starts with the creation of an initial population of trading strategies, represented as mathematical formulas or algorithms. Each strategy is evaluated based on its performance against historical data and a fitness function. The fitness function measures the profitability and risk-adjusted returns of the strategy.

The evolutionary algorithm then applies genetic operators such as mutation, crossover, and selection to the population. These operators mimic the process of genetic variation, recombination, and natural selection. Through successive generations, the algorithm evolves and improves the trading strategies, discarding the less profitable ones and favoring the more successful ones.

As the algorithm progresses, it explores the search space of possible trading strategies, gradually converging towards profitable patterns. This iterative process allows the algorithm to adapt and evolve, discovering formulaic alphas that can generate consistent returns.

One of the advantages of using evolutionary algorithms is their ability to handle complex and nonlinear relationships in the data. Traditional statistical models often make assumptions about linearity and normality, which may not hold in financial markets. Evolutionary algorithms can capture more intricate patterns and exploit non-linear relationships, leading to the discovery of unique and profitable trading strategies.

Another benefit of using evolutionary algorithms is their ability to incorporate domain knowledge and constraints. Traders can define specific rules, constraints, or preferences that the algorithm should adhere to. For example, a trader may want to avoid certain types of trades or limit the exposure to specific sectors. By incorporating these constraints into the fitness function or genetic operators, the algorithm can generate trading strategies that align with the trader's preferences.

Once the algorithm converges and identifies promising trading strategies, the next step is to validate and test these strategies using out-of-sample data. This step is crucial to ensure that the discovered formulaic alphas are not overfitting the historical data and can generalize to new market conditions.

Automation using Evolutionary Algorithms

One of the key advantages of using evolutionary algorithms in the process of finding formulaic alphas is automation. These algorithms can significantly reduce the manual effort and time required for strategy development and testing.

With traditional manual approaches, traders often have to manually explore and test various trading strategies, which can be a time-consuming and labor-intensive process. By automating the search for profitable trading patterns, evolutionary algorithms can expedite the discovery of formulaic alphas and free up traders' time for other critical tasks.

Automation also allows for a more systematic and objective approach to strategy development. Human biases and emotions can often influence manual strategy development, leading to suboptimal results. Evolutionary algorithms, on the other hand, are driven by mathematical optimization principles and are not subject to human biases. This objectivity can lead to the discovery of more robust and profitable trading strategies.

Furthermore, automation enables the algorithm to continuously adapt and evolve as new data becomes available. Financial markets are dynamic and constantly changing, requiring trading strategies to adapt to evolving market conditions. By automating the process, traders can ensure that their formulaic alphas remain relevant and effective over time.

the process of finding formulaic alphas involves several key steps, including data sourcing and feature computation, as well as generating formulaic alphas using evolutionary algorithms. These algorithms automate the search for profitable trading patterns, while data sourcing and feature computation provide the necessary inputs for analysis. By leveraging the power of evolutionary algorithms and automation, traders can enhance their ability to discover and capitalize on formulaic alphas in the financial markets.