Weighted Alpha: Meaning, Calculation, Inferences

What Is Weighted Alpha?

Weighted alpha measures the performance of a security over a certain period, usually a year, with more importance given to recent activity.

Alpha is a term used to describe an investment strategy’s ability to beat the market. It is often referred to as “excess return” or “abnormal rate of return,” indicating that markets are efficient and returns that exceed the market as a whole are not possible.

Key Takeaways

• Weighted alpha measures the performance of a security over a certain period, usually a year, with more importance given to recent activity.
• A positive weighted alpha shows that the security produced a return greater than the benchmark; a negative measure indicates the converse.
• Weighted alpha can identify companies that have shown a strong trend over the past year and, more specifically, companies whose momentum is building.

Understanding Weighted Alpha

Weighted alpha is a measure of how much a security, like a stock, has risen or fallen over a defined period, usually a year. Emphasis is placed on recent activity by assigning higher weights to later performance measurements. This helps to provide a return figure that has a greater focus on the most current period, which is more relevant for analyzing the security. Technical analysts and those who rely on analytics for trading decisions often use this metric.

Weighted alpha is calculated using mathematical calculations to arrive at an alpha performance figure. Alpha is a measure of risk-adjusted performance relative to a benchmark. It can also be a reflection of the effectiveness of a firm’s management team.

For example, a stock that had returns on par with the benchmark, adjusted for the level of risk assumed, has an alpha of zero. A positive alpha shows that the stock produced a return greater than the benchmark, while a negative alpha indicates the converse.

Weighted Alpha Calculation

Weighted calculations assign weights based on various factors. In a weighted alpha calculation, higher weight is typically given to more recent time period returns.

Weighted alpha calculations usually focus on one year of a security’s return. If a security has a positive weighted alpha, investors can assume its price has been gaining over the past year. Conversely, if a security’s price has a negative weighted alpha, investors can assume that the one-year price return is lower.

Weighted Alpha = ∑ (W × α) n where: W = weight assigned to each data point α = alpha n = number of days in defined time series

In a weighted alpha calculation, weights can vary based on preferences or technical analysis software programs. Some weighted alpha calculations may assign weights by quartiles, while others use a standard decreasing weight methodology.

Alpha is often used in conjunction with beta (the Greek letter β), which measures the broad market’s overall volatility or risk.

Weighted Alpha Inferences

Weighted alpha is used by many investors, particularly technical analysts, to support buy and sell signals. It helps identify companies with a strong trend over the past year and whose momentum is building. A positive weighted alpha supports a bullish buy signal, while a negative weighted alpha supports a bearish sell signal.

For example, if a stock is approaching its support trendline with a positive weighted alpha, it affirms that the stock’s price has largely been gaining over the last year, supporting a bullish push higher.

In another scenario, if a stock’s price is exceeding its resistance band in a Bollinger Band channel and has a positive weighted alpha, it is more likely to break beyond its resistance level and move higher. Therefore, the weighted alpha could support a buy trade in this scenario.

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