Algorithmic trading relies on computer programs that execute algorithms to automate some, or all, elements of a trading strategy. Algorithms are a sequence of steps or rules to achieve a goal and can take many forms. In the case of machine learning (ML), algorithms pursue the objective of learning other algorithms, namely rules, to achieve a target based on data, such as minimizing a prediction error. In this article, we have a look at use cases of ML and how it is used in algorithmic trading strategies.
These algorithms encode various activities of a portfolio manager who observes market transactions and analyzes relevant data to decide on placing buy or sell orders. The sequence of orders defines the portfolio holdings that, over time, aim to produce returns that are attractive to the providers of capital, taking into account their appetite for risk.
This article is an excerpt taken from the book ‘Hands-On Machine Learning for Algorithmic Trading’ written by Stefan Jansen. The book explores effective trading strategies in real-world markets using NumPy, spaCy, pandas, scikit-learn, and Keras.
Ultimately, the goal of active investment management consists in achieving alpha, that is, returns in excess of the benchmark used for evaluation. The fundamental law of active management applies the information ratio (IR) to express the value of active management as the ratio of portfolio returns above the returns of a benchmark, usually an index, to the volatility of those returns. It approximates the information ratio as the product of the information coefficient (IC), which measures the quality of forecast as their correlation with outcomes, and the breadth of a strategy expressed as the square root of the number of bets.
The use of ML for algorithmic trading, in particular, aims for more efficient use of conventional and alternative data, with the goal of producing both better and more actionable forecasts, hence improving the value of active management.
Quantitative strategies have evolved and become more sophisticated in three waves:
- In the 1980s and 1990s, signals often emerged from academic research and used a single or very few inputs derived from the market and fundamental data. These signals are now largely commoditized and available as ETF, such as basic mean-reversion strategies.
- In the 2000s, factor-based investing proliferated. Funds used algorithms to identify assets exposed to risk factors like value or momentum to seek arbitrage opportunities. Redemptions during the early days of the financial crisis triggered the quant quake of August 2007 that cascaded through the factor-based fund industry. These strategies are now also available as long-only smart-beta funds that tilt portfolios according to a given set of risk factors.
- The third era is driven by investments in ML capabilities and alternative data to generate profitable signals for repeatable trading strategies. Factor decay is a major challenge: the excess returns from new anomalies have been shown to drop by a quarter from discovery to publication, and by over 50% after publication due to competition and crowding.
There are several categories of trading strategies that use algorithms to execute trading rules:
- Short-term trades that aim to profit from small price movements, for example, due to arbitrage
- Behavioral strategies that aim to capitalize on anticipating the behavior of other market participants
- Programs that aim to optimize trade execution, and
- A large group of trading based on predicted pricing
The HFT funds discussed above most prominently rely on short holding periods to benefit from minor price movements based on bid-ask arbitrage or statistical arbitrage. Behavioral algorithms usually operate in lower liquidity environments and aim to anticipate moves by a larger player likely to significantly impact the price. The expectation of the price impact is based on sniffing algorithms that generate insights into other market participants’ strategies, or market patterns such as forced trades by ETFs.
Trade-execution programs aim to limit the market impact of trades and range from the simple slicing of trades to match time-weighted average pricing (TWAP) or volume-weighted average pricing (VWAP). Simple algorithms leverage historical patterns, whereas more sophisticated algorithms take into account transaction costs, implementation shortfall or predicted price movements. These algorithms can operate at the security or portfolio level, for example, to implement multileg derivative or cross-asset trades. Let’s now have a look at different applications in Trading where ML is of key importance.
Use Cases of ML for Trading
ML extracts signals from a wide range of market, fundamental, and alternative data, and can be applied at all steps of the algorithmic trading-strategy process. Key applications include:
- Data mining to identify patterns and extract features
- Supervised learning to generate risk factors or alphas and create trade ideas
- Aggregation of individual signals into a strategy
- Allocation of assets according to risk profiles learned by an algorithm
- The testing and evaluation of strategies, including through the use of synthetic data
- The interactive, automated refinement of a strategy using reinforcement learning
Supervised learning for alpha factor creation and aggregation
The main rationale for applying ML to trading is to obtain predictions of asset fundamentals, price movements or market conditions. A strategy can leverage multiple ML algorithms that build on each other. Downstream models can generate signals at the portfolio level by integrating predictions about the prospects of individual assets, capital market expectations, and the correlation among securities. Alternatively, ML predictions can inform discretionary trades as in the quantamental approach outlined above. ML predictions can also target specific risk factors, such as value or volatility, or implement technical approaches, such as trend following or mean reversion.
ML has been used to allocate portfolios based on decision-tree models that compute a hierarchical form of risk parity. As a result, risk characteristics are driven by patterns in asset prices rather than by asset classes and achieve superior risk-return characteristics.
Testing trade ideas
Backtesting is a critical step to select successful algorithmic trading strategies. Cross-validation using synthetic data is a key ML technique to generate reliable out-of-sample results when combined with appropriate methods to correct for multiple testing. The time series nature of financial data requires modifications to the standard approach to avoid look-ahead bias or otherwise contaminate the data used for training, validation, and testing. In addition, the limited availability of historical data has given rise to alternative approaches that use synthetic data.
Trading takes place in a competitive, interactive marketplace. Reinforcement learning aims to train agents to learn a policy function based on rewards.
In this article, we briefly discussed how ML has become a key ingredient for different stages of algorithmic trading strategies. If you want to learn more about trading strategies that use ML, be sure to check out the book ‘Hands-On Machine Learning for Algorithmic Trading’.