Preserving Stock Signals in Sector-Neutral Portfolio Construction

# Making a Trading Strategy Industry-Neutral


# Making a Trading Strategy Industry-Neutral












Here's a toy example of a simple trading strategy that I just read about (from a book called "Trading Alphas"):

Let's say that we expect a stock that's been going up over the past week to now go down, since traders are expected to book profits and the price will accordingly decrease. Our trading universe has only 2 stocks - Google and Apple. We could have a trading strategy in which our position in a stock is given by

position $ = - ($past week return$)$.

Using the above, we get positions in Google and Apple as $+2.5$ and $+7.5$ respectively. So far so good. Now, suppose we're expecting some bad event for the technology sector. A long position in these stocks could result in heavy losses. The book prescribes that one way to avoid such losses is to develop a sector-neutral strategy - the sum of positions of individual stocks in that sector would be $0$, i.e., take a long position in either Google or Apple and an equal short position in the other.

"This would change the old values of $+2.5$ and $+7.5$ to $-5.0$ and $+5.0$ for Google and Apple, respectively."

I can understand that we go long in Apple since our previous strategy prescribed a higher positive position in it ($+7.5$ as against only $+2.5$ for Google). But we could just as easily have had a different prior strategy that similarly assigned a more positive position to Apple. So the end result would've been similar - a sector neutral strategy that assigns $+x$ to Apple and $-x$ to Google.

In that sense, doesn't the sector-neutral strategy make our previous trading strategy completely irrelevant (apart from the magnitude of $x$)?

## Answer by Comp_Warrior (score 2, accepted)

https://quant.stackexchange.com/a/32354

One thing you could do is make your trading signal sector neutral. For example, you can z-score your signals within each sector. For your example, your signals would be transformed from $(2.5,7.5)$ to $(-1.0,1.0)$. Your portfolio construction methodology is to take weights directly proportional to the signals, so in this case, having symmetrical weights makes sense. If you have more stocks, the signals will be transformed differently, for example $(2.5, 4.0, 7.5)$ is transformed to $(-1.03, -0.32, 1.35)$. Now you can see the situation is not symmetrical, and the strong signals are penalized less than the weak ones. So the information of your strategy is not 'lost' under the ranking operation.

An alternative would be to think of different ways to construct your portfolio. For example, you can think of explicit sector weight constraints in a Markowitz type optimization.

## Answer by madilyn (score 3)

https://quant.stackexchange.com/a/32331

Yes, your initial strategy would be rendered irrelevant since all that is saying is that you constrain

$w_1 + w_2 = 0$

and so your solution is undefined if $w_1,w_2>0$. One way you could make your strategy useful under a sector-neutral constraint is to change it into an optimization that minimizes the differences between actual weights and unconstrained weights, subject to the above constraint. e.g. Find

$\underset{w_1',w_2'}{\min} \left(w_1'-w_1\right)+\left(w_2'-w_2\right)$

subject to

$w_1 + w_2 = 0$