Lets assume that I have an equity strategy that generates signals intraday to buy and sell. I run this strategy across the SP500 names. Now within my strategy I want to incorporate a method to help me decide if I want to take a certain trade on or not, based on my current portfolio composition.

Currently I have a very simple idea of how to do this. I compute the beta of each symbol I want to trade against the market index and look at my beta exposure to the market. If I am above a certain threshold, I don't take long or short signals accordingly.

Just wondering if there are better methods out there which would help me measure my exposure to the market and various sectors ? My aim here is to make sure that I am not too exposed to one sector or the market in general , before taking on additional positions.

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    $\begingroup$ Factor models and Value at Risk are the common approaches taken by the pros. Nothing about them is linked to the time period. That is, they do work intraday. $\endgroup$ – Brian B Feb 2 '12 at 14:10
  • $\begingroup$ Agreed w/ @BrianB. Along the same lines you can also prioritize trades by identifying which securities have the lowest (perhaps negative) marginal contribution to risk $\endgroup$ – Ram Ahluwalia Feb 2 '12 at 15:46
  • $\begingroup$ @QuantGuy .. Might be a very stupid question but can you explain to me how I can use marginal contribution to risk in my case? $\endgroup$ – silencer Feb 3 '12 at 1:51

The first issue you need to care about using intraday data to compute beta is the Epps effect (collapse of correlation when you zoom in).

This effect comes from different parts, the first being that if you try to compute correlations at high frequency, above a given frequency the probability that your 2 secutities move simultaneously is zero. Consequently their empirical correl is zero.

To solve this, you need to use an enhanced estimator of correlations (like Yoshida's one, or using Hawkes process-oriented results).

Then, the best way to do that properly is to include your signal in a "optimal liquidation portfolio". Have a look at Market Microstructure knowledge needed to control an intra-day trading process. Section 4.1 you have optimal liquidation with arbitrage (on one stock for the sake of notations, but it is easy to extend to a basket). It is a chapter to be publish in the Handbook of systemic risk.

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  • $\begingroup$ Looking forward to your link $\endgroup$ – silencer Apr 17 '12 at 2:39

Assuming you have an "optimal" target portfolio (Using BL model or otherwise), what you should be looking is that expected return enhancement from divergence from the previously computed "optimal" w.r.t. the marginal contribution to risk.

NB: optimal is in inverted commas.

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