### Reverse Engineering DynamicHedge’s Alpha Curves, Part 1 of 3: Dynamic Time Warping

DynamicHedge recently introduced a new service called “alpha curves”: the main idea is to find patterns in returns after certain events, and present the most frequently occurring patterns. In their own words, alpha curves “represent a special blend of uniqueness and repeatability”. Here’s what they look like, ranked in order of “pattern dominance”. According to them, they “use different factors other than just returns”. We can speculate about what other factors go into it, possibly something like maximum extension or the timing of maxima and minima, but I’ll keep it simple and only use returns.

In this post I’ll do a short presentation of dynamic time warping, a method of measuring the similarity between time series. In part 2 we will look at a clustering method called K-medoids. Finally in part 3 we will put the two together and generate charts similar to the alpha curves. The terminology might be a bit intimidating, but the ideas are fundamentally highly intuitive. As long as you can grasp the concepts, the implementation details are easy to figure out.

To be honest I’m not so sure about the practical value of this concept, and I have no clue how to quantify its performance. Still, it’s an interesting idea and the concepts that go into it are useful in other areas as well, so this is not an entirely pointless endeavor. My backtesting platform still can’t handle intraday data properly, so I’ll be using daily bars instead, but the ideas are the same no matter the frequency.

So, let’s begin with why we need DTW at all in the first place. What can it do that other measures of similarity, such as Euclidean distance and correlation can not? Starting with correlation: one must keep in mind that it is a measure of similarity based on the difference between means. Significantly different means can lead to high correlation, yet strikingly different price series. For example, the returns of these two series have a correlation of 0.81, despite being quite dissimilar.

A second issue, comes up in the case of slightly out of phase series, which are very similar but can have low correlations and high Euclidean distances. The returns of these two curves have a correlation of .14:

So, what is the solution to these issues? Dynamic Time Warping. The main idea behind DTW is to “warp” the time series so that the distance measurement between each point does not necessarily require both points to have the same x-axis value. Instead, the points further away can be selected, so as to minimize the total distance between the series. The algorithm (the original 1987 paper by Sakoe & Chiba can be found here) restricts the first and last points to be the beginning and end of each series. From there, the matching of points can be visualized as a path on an n by m grid, where n and m are the number of points in each time series.

The algorithm finds the path through this grid that minimizes the total distance. The function that measures the distance between each set of points can be anything we want. To restrict the number of possible paths, we restrict the possible points that can be connected, by requiring the path to be monotonically increasing, limiting the slope, and restricting how far away from a straight line the path can stray. The difference between standard Euclidean distance and DTW can be demonstrated graphically. In this case I use two sin curves. The gray lines between the series show which points the distance measurements are done between.

Notice the warping at the start and end of the series, and how the points in the middle have identical y-values, thus minimizing the total distance.

What are the practical applications of DTW in trading? As we’ll see in the next parts, it can be used to cluster time series. It can also be used to average time series, with the DBA algorithm. Another potential use is k-nn pattern matching strategies, which I have experimented with a bit…some quick tests showed small but persistent improvements in performance over Euclidean distance.

If you want to test it out yourselves, there are plenty of tools out there. I’m using the NDTW .NET library. There are libraries available for R and python as well.