Advance Trading Algorithms

On basis of Accruals
Accruals = (Change in CA – Change in Cash) – (Change in CL – Change in STD – Change in TP) – Dep

CA – Current Assets

CL – Current Liabilities

STD – Short-Term Debts

TP – Tax Payable

Dep – Depreciation

Income = Cash from Operating/Continuous Activities .1

Average Total Assets

We divide the cash from operating activities by average total assets to find an optimum ratio in case
the 2 companies that are being compared are comparable.

Accrual Component = Accrual 2

Average Total assets
Cash Component = Income – Accrual
1–2
Different Hypothesis –
Hypothesis 1 - The persistence of current earnings performance is decreasing in the magnitude of
the accrual component of earnings and increasing in the magnitude of the cash flow component of
earnings.
Hypothesis 2 (i) – The earnings expectations embedded in stock prices fail to reflect fully the higher
earnings persistence attributed to the cash flow component of earnings and the lower earnings
persistence attributable to the accruals component of earnings.
Hypothesis 2 (ii) – A trading strategy taking a long position in the stock of firms reporting relatively
low levels of accruals and a short position in the stock of firms reporting relatively high levels of
accruals generated positive abnormal stock returns.
Hypothesis 2 (iii) – The abnormal stock returns predicted in H2(ii) are clustered around future
earnings announcement dates.

Idiosyncratic Risk – Risks that are applicable to a specific company and do not affect the working of
the entire economy as a whole. Example Court case of a specific company, Death of a CEO, ETC.
Systematic Risk – Risk that affects the working of the economy as a whole. Example of Inflation,
Deflation, Recession, ETC.

On basis of BETA
Beta
The Sensitivity of each company to Systematic Risk is known as Beta.

Alpha
Alpha is the extraordinary return that we make.

Some key points about the eta.

 Companies that have high beta are known as aggressive stocks or growth stocks.
 Companies that have high growth or high uncertainty or high exposure to systematic risk
have a high beta.
 Companies that have how growth usually have low Beta and are known as defensives.

Risk-Free Return – Guaranteed Return that we will get.

Market Return – Interest that we actually earn from the market is known as market return.
Expected Return = Risk Free Return + Beta*(Market Return – Risk Free Return)

Alpha = The rate we Actually get – Expected Return

Betting Against Beta

 High Beta Stocks are generally overvalued due to them being high on risk. So short on high
beta firms.
 Low Beta Stocks are generally undervalued due to them being low on risk. So long on low
beta firms.
 High Beta Assets mean more risky assets enabling investors to invest higher amounts
increasing the value of the stock resulting in lower profits and lower returns giving lower
alpha.
 While on the other hand, Low Beta Assets mean less risky assets that therefore investors
don’t go or have high investments keeping the stock price relatively low and therefore giving
high alpha.
 We can get the beta of different firms online and need not calculate them all the time.

Process
  Rank the stocks based and beta(monthly).
 Find the median beta of all the firms.
 Next, divide the firms into above-median and below-median beta stocks.

Strategy
 First, find the median beta of all the firms.
 Calculate the average beta of each company for a period of 6 months. This 6 months is the
time just before investing in the stock.
 Stocks that have an average beta more than the median beta are overvalued and stocks that
have an average beta less than the median beta are undervalued. (Refer to the first 2 points
in betting against beta).
 The optimum time to invest in the market in this strategy is 1 month.

On basis of the MOMENTUM STRATEGY

Based on Cross-Sectional Momentum Strategy

Momentum – Momentum refers to the tendency of rising stock prices to rise further and
falling stock prices to fall further.

Efficient market Hypothesis

According to this hypothesis, security prices are said to reflect all available information.
But momentum goes against this as it says that rising stock prices rise further and vice versa. This
terms momentum as an Anomaly.

Anomaly
When security or a group of securities perform contrary to the notion of efficient markets, we call it
an anomaly.

How do we measure the momentum of a stock?

Momentum is the total return of stock(including the dividends of the stock) over the last n months.
This period of n months is called the lookback period. The lookback period can be anything between
1 week to 5 years. It is calculated monthly.
For instance
 Net Return = 10%
Then Gross Return = 0.1 + 1 = 1.1
 Net Return = -10%
 Then Gross Return = -0.1 + 1 = 0.9
For strategy, we take the lookback period to be 12 months and a holding period of 3 months. We do
the same step above for all 12 months and multiply them and then subtract 1 from it giving us a
percentage for the same. This percentage is the momentum for the last 12 months of that firm.

Momentum Types
Short-Term Momentum – The lookback period is anything below 1 month. According to research,
stocks with positive short-term momentum, are losers in the near-term future. And short-term
losers, that is, stocks with negative short-term momentum, are winners in the near-term future. This
means, when we measure momentum over a short time horizon, we can expect to see a reversal in
short-term future items.

Intermediate-Term Momentum – The lookback period is anything between 3 months to 12 months.

Research finds out there is no return reversal. This means that the intermediate-term momentum
trends in the near future and not reversed. This is different from what we have observed in the case
of short-term and long-term momentum. This is an anomaly.

Long-term Momentum – The Lookback period is anything between 3 years to 5 years. They show
that losers outperform winners in the next three years. The same results hold good for a look-back
period of five years also. This shows that long-term momentum, in a way similar to short-term
momentum, leads to return reversals in the future.

Notes
 There is no return reversal but continuation of returns when you use a intermediate term
momentum.
 The best strategy is when you use a look-back period of 12 months and a holding period of 3
months.
 The Third point, they find that the excess returns that you get by using an intermediate-term
momentum strategy are not long-lasting. In other words, if you use a look-back period of 12
months and hold the stocks for a long term, then again you experience return reversals.

Data Preparation
Screen out the il-liquid stocks and keep only the liquid stocks.

You will now calculate the daily returns from these stock prices. You'll take these daily returns, and
compound them to calculate the monthly returns.

Calculation of intermediate-term momentum

The second step is the calculation of intermediate-term momentum. We make a slight modification
to the way we calculate momentum. We calculate the cumulative 12-month returns after removing
the last month’s returns. By skipping a month, we award the short-term momentum effects.
Creating winner and looser portfolio
Rank all the firms in ascending order in order of their newly calculated momentum in the above step.
The next step is to divide all these firms into deciles. Based on deciles we create an equally weighted
portfolio.
The lower decile portfolio is the looser portfolio while the upper decile portfolio is the winners’
portfolio.
Our strategy will involve, longing the winners’ portfolio and shorting the losers’ portfolio.

Trading
As mentioned previously, long the winner portfolio, and short the loser portfolio. That is you're
longing for stocks with the strongest momentum and shorting stocks with the lowest momentum.

The results show that returns from the winners’ portfolios are more, compared to the returns from
the losers’ portfolios.

Holding Period
Research shows that abnormal returns generated in the first year dissipate in the following 2 years.

If we study returns for three years after the creation of a portfolio, in the first year the portfolio
generates positive returns. But the returns keep decreasing in the subsequent two years. So it is not
advisable to have a very long holding period.

Normalized Return
Normalized earnings are adjusted to remove the effects of seasonality, revenue, and expenses that
are unusual or one-time influences.

Average Effective Annual Return

An effective annual interest rate is the real return on a savings account or any interest-paying
investment when the effects of compounding over time are taken into account. It also reflects the
real percentage rate owed in interest on a loan, a credit card, or any other debt.

Effective Annual Interest Rate=(1+ni)n−1

i=Nominal interest rate
n=Number of periods

Time Series Momentum

Absolute Momentum is calculated based on a stock’s historical returns, independently from the
returns of the other stocks.
Cross-Sectional Momentum(Relative Strength Momentum)
Relative strength momentum is a measure of stock’s performance, relative to
other stocks.

Based on Time Series Momentum Strategy

This is the new version of Momentum Anomaly. This anomaly shows that each security's own past
return is a predictor of future returns. In simple words, what this means is the past 12-month
excess return of each stock can be used to predict its future return.

Research has shown that a portfolio of very diversified stocks based on the time series momentum
strategy is stable and robust.

(NOTE)
NO MATTER WHAT THE STRATEGY MAY BE,
DIVERSIFICATION IN STOCKS IS A MUST AND SHOULD
NEVER BE AVOIDED

Call Option – is buying the stock. When we book the stock to be bought after a certain point of time
at the price we fix now but pay a small amount of premium(say booking amount) right now is called
a call option. In this, the buyer is supposed to pay the price of the stock that is going on at the time
when he buys the rights to buy the stock. So when the price of the stock falls then the buyer has to
face a loss of the premium amount

On basis of G’s Score

This Strategy is basically to separate low book to market firms into potential winners and
potential losers.

Firstly lets categorise the firms in 3 major fields –

1. Firms – that are really low book to market firm
2. Firms – that are low book to market because of being overvalued in
market
 3. Firms – that are low book to market because of temporary reduction of
book value
There are 8 signals that are divided into 3 groups and each group takes care of each of the
category mentioned above.
Group 1 – This group is defined keeping in mind the firms that are actually low book to
market firms. The group divides the above firms into potential winners and potential losers
based on the modified measures of statement of profitability.
Group 2 – This group is defines on the basis of firms that are low book to market firms
because of being overvalued in the market. Though overvaluation is a temporary thing and
the original firm might not fall into the low book to market category originally. This is mainly
because markets naively interpret future values from current fundamentals. The signals in
this group takes care of this problem.
Group 3 – This group is defined for the firms that have low book to market ratio because of
temporary reduction in book value due to accounting rules.

Group 1 (Based on traditional financial method of profitability)

(To separate firms that are profitable from the firms that are not)
(On basis of Profitability)
Firms that are profitable now are likely to have strong fundamentals and the same might continue in
the future also. We have to separate such firms from the weak firms.

G1(Earning Returns on Assets) – It is defined as the ratio of net income before extraordinary
items divided by average total assets. Here the earning returns on assets of firms is compared with
the median earning returns of all the low book to market firms in the same industry at the same
time as the same firm. We assign a value 1 if the firm’s return on asset based on earnings is greater
than the median return on assets for low book to market firms in the same industry and 0 otherwise.

G2(Cash Flow Returns on Assets) – Cashflow return on asset is defined as the ratio of cash
from operations scaled by average total assets. The signal is equal to 1 if the firm’s cash flow return
in asset exceeds the median for all low book to market firms in the same industry and 0 otherwise.

G3(Accruals) - Firms with a greater accrual component in their earning generally underperform
in the future on the basis of the lower quantity of their earnings. If the cash flow from operations
exceed net income then we assign a value 1 to G3 and if the cash flow from operations does not
exceed net income then we assign a value 0 to G3.

Group 2 (Used to take care of the firms that are overvalued in the
market)
(Made for firms that are currently overvalued)
(Based on Variability of performance)
G4(Based on Stability of Earnings) – It is calculated as variance of firm’s quarterly earnings
return on assets over the last 4 years. If the firm’s earnings variability is less than the median
average earnings variability of all low book-to-market0 firms in the same industry then it is favorable
for the firm and a value of 1 is assigned.

G5(Sales Growth Variability) – It is defined as the variance of a firm’s quarterly growth of

sales over the last 4 years. If the firm’s sales growth variability is less than the median sales growth
variability of thee the low book-to-market firms in the same industry then it is favorable to the firm
and we assign a value of 1 to G5 other a value of 0 is given.

Group 3(To take care of the firms whose book value has been
temporarily suppressed due to accounting rules)

(Based on the expenses on Advertisement, Capital Expenditure, and

Research And Development)
Firstly, the respective expense measure of the firm is to be calculated and
compared with the median R and D intensity value for all the low book-to-
market firms in this same industry.

G6(Research And Development Intensity) – It is the amount spend on R and D divided by

the assets at the beginning of the year. First the R and D measure of the firm is to be calculated and
compared with the median R and D intensity value for all the low book to market firms in this same
industry. If the R and D density measure is greater than the industry median, it means that is
spending more on R and D as compared with the most of the other firms in the industry. It is a
favorable sign for the firm and we assign a value of 1 to the firm 0 otherwise.

G7(Capital Expenditure Intensity) – It is the amount spent on capital Expenditure scaled by

the assets at the beginning of the year. We calculate the capital expenditure intensity value of the
firm and compare it with the median capital expenditure value for all the market firms in the same
industry. If the capital expenditure and density measure are greater than the industry median then it
is a positive sign for the firm and a value of 1 is assigned and 0 otherwise.

G8(Advertisement Expense Intensity) – It is the amount spent on Advertisement expense

scaled by the assets at the beginning of the year. We calculate the advertisement expense intensity
value of the firm and compare it with the median advertisement expenditure value for all the market
firms in the same industry. If the advertisement expenditure and density measure are greater than
the industry median then it is a positive sign for the firm and a value 1 is assigned and 0 otherwise.

Strategy
Sample Selection –
We have to calculate low book to market ratios for the current and the previous year

The firms with negative book to market ratios are not used in this analysis.

Next arrange the firms in ascending order according to their book to market ratios of previous year.

Divide them into quintiles.

Data Collection –
Gather all the financial information available for these low book to market firms. In case of lack of
past year’s information, the information for the current year is used.

Consideration of only those firms which have earnings and cash flow information available.

This step involves calculation of signals. The three signals relating to profitability and cash flows that
is all the three groups of signals.

What trading algorithm is

Types

Uses

Practical use

Conclusion

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