Model Description

William F. Sharpe and Harry M. Markowitz won in 1990 a Nobel Prize for the work in the 1970’s on what is now called Modern Portfolio Theory. 

Sharpe’s formula expressed mathematically is y = (Beta)x + Alpha
where y is the price of a stock and x is a market index such as the NASDAQ composite. Alternatively, y can be the daily percentage gain for a stock and x can be the daily percentage gain (or loss) of a market index. Beta and Alpha are calculated for a given stock/index pair by linear regression.  Along with Alpha and Beta, R² is calculated and tells the “goodness” of the fit.

Many people have heard of Beta.  Beta is the slope of the line described by the equation.  This tells us how volatile a stock is relative to the chosen index. A stock with a Beta of 2 moves twice as much as the index has moved.

Alpha is the y-intercept in the equation and describes the movement of the stock which is independent of the movement of the index. The alpha values for most stocks are very low. So, for most stocks, especially large well-followed stocks, the stock price movement can be represented as a constant (Beta) times a stock index.  Sharpe and Markowitz dismissed alpha as insignificant. They said for all intents and purposes it was negligible.  Most stocks do have alphas near zero. However, a small number of stocks and ETFs do not.  Most of these are smaller lesser known stocks.  What makes high alpha stocks and ETFs so unique is that these they move up even if the market goes nowhere. 

The model determines the strength or weakness of individual ETFs by calculating alphas for all ETFs in the stock market over three different time periods. Trends in these alphas are then examined and a list of possible ETFs are generated.  ETFs are then selected based on liquidity and portfolio balance.

Having a good model is only one component to making money. Another important component is good money management strategy. A fantastic model combined with poor money management will likely make no money or lose money. Disciplined ETF Trading has incorporated a good money management strategy as a fundamental part of the model.  The portfolio will at times have a balance of long ETFs and short ETFs and will at times have a cash position when market conditions are highly volatile or shifting.  A good model combined with good money management will make you great money.

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