To select stocks to serve as representatives of various sectors or market dimensions, an advanced technique called factor analysis may be used. This is a mathematical method employed to determine groups of stocks that tend to move together under the influence of some common force or "factor."
Factor analysis is a technique that can reveal a great deal about the structure of the stock market. The fundamental idea behind factor analysis is the decomposition of a set of observable variables, such as stock prices, into a smaller number of underlying or hidden variables. The small number of hidden variables is chosen to account for as much variation in the more numerous observed variables as possible. Originating in the field of psychometrics, factor analysis was developed in the quest for the fundamental traits of intellect and personality insofar as these could be determined from correlations between scores on mental tests. In the current application, factor analysis can reveal the common, underlying themes that explain the correlations in intra day movement between different stocks. In a sense, factor analysis allows the discovery of sets of variables that move together as if determined by some common underlying influence or force. Factor analysis can help the trader isolate groups of stocks that have price behavior that correlates over time.
Factor analysis allows you to find several groups or clusters of stocks having the following properties:
- Within each group, the stocks correlate highly with one another, exhibiting a coherence in their intra day movement.
- Between groups, stocks have lower correlations and exhibit distinct patterns of movement. The stocks in distinct groups behave as if their prices are being influenced by different underlying forces.
Finally, factor analysis provides one of the most elegant ways to find proxy stocks for trading broad market groupings. The groups found by factor analysis are more precise and have greater empirical grounding than those constructed by analysts.
