Alpha Trading: Profitable Strategies That Remove Directional Risk

Author: Perry Kaufman Categories: Trading Systems, Quantitative Trading, Risk Management

Quick Summary

Perry Kaufman presents market-neutral and statistical arbitrage strategies including pairs trading (equities and futures), risk-adjusted spreads, cross-market trading using a proprietary Stress Indicator, and traditional stat-arb methods. The book covers strategies that profit from relative price movements between correlated instruments while hedging away directional market risk.

Detailed Summary

Perry Kaufman's Alpha Trading (2011, Wiley) addresses the challenge of generating consistent returns regardless of market direction by focusing on relative value strategies. Kaufman, author of the encyclopedic Trading Systems and Methods, brings decades of quantitative trading experience to the subject.

The book opens with a philosophical chapter on uncertainty, covering the inevitability of price shocks, complexity and contagion risk, and the importance of accepting that performance will include drawdowns. Chapter 2 examines the importance of price noise, distinguishing between different market regimes and how noise characteristics vary across equity, futures, and currency markets. The chapter introduces methods for capitalizing on the trend of noise itself.

Chapters 3-4 cover pairs trading in equities and futures respectively. The equity pairs section uses home builders as a detailed case study, demonstrating the complete process: pair selection based on correlation, target volatility determination, execution mechanics, stop-loss placement, and portfolio construction from multiple pairs. The futures chapter extends pairs trading to inflation-sensitive commodities, energy markets, equity index pairs, London Metal Exchange metals, and interest rate futures.

Chapter 5 introduces risk-adjusted spreads, a more sophisticated approach that accounts for volatility differences between paired instruments. Case studies include Dell/Hewlett-Packard equity pairs and precious metals ratios (platinum/gold). Chapter 6 presents Kaufman's proprietary Stress Indicator for cross-market trading, applied to gold/copper/platinum relationships, mining companies, agribusiness pairs, and energy producers.

Chapter 7 revisits pairs trading using the Stress Indicator, applying it to futures markets and equity index relationships. Chapter 8 covers traditional market-neutral trading, including basic concepts, volatility-adjusting position sizes, and large-scale programs like "Arbing the Dow." Chapter 9 explores additional stat-arb methods including new highs/new lows strategies, merger arbitrage, and creating custom index arbitrage programs.

Throughout, Kaufman provides downloadable spreadsheet tools for readers to implement the strategies, making this a genuinely practical resource for quantitative traders seeking to generate alpha independent of market direction.