DataTalks.Club

Machine Learning for Algorithmic Trading

by Stefan Jansen

The book of the week from 22 Feb 2021 to 26 Feb 2021

The explosive growth of digital data has boosted the demand for expertise in trading strategies that use machine learning (ML). This thoroughly revised and expanded second edition enables you to build and evaluate sophisticated supervised, unsupervised, and reinforcement learning models.

This edition introduces end-to-end machine learning for the trading workflow, from the idea and feature engineering to model optimization, strategy design, and backtesting. It illustrates this workflow using examples that range from linear models and tree-based ensembles to deep-learning techniques from the cutting edge of the research frontier.

Questions and Answers

Doink

How good are the strategies mentioned in the book good enough to make decent money in real time? Vladimir Finkelshtein basically completed my question, absolutely valid points with the whole Gamestock Saga and BTC price pump with just one tweet and investment by Musk.

Vladimir Finkelshtein

One of the most successful trading strategies is market manipulation. How can one make sure that ML does not learn to do it? (because it will, since it tries to optimize the profits)
From the other side, how can one identify that the market is being manipulated? Nowadays, a single tweet can wreak havoc in the markets.

Aleix

Hi, Stefan Jansen! Nice to meet you.
It’s actually a great timing for me, since I am actually very interested in this topic and was thinking of developing my bachelor thesis around an algotrading system 😄
My question is: how would you describe the use of ML in the algotrading scenario? Has it been a game-changer and everyone uses it now? Or just another tool that sometimes works and sometiems don’t?
Thanks a lot!

Hong-Ngoc Emily Tran

Who should read the book? Can a normal banker with somewhat knowledge in Data Analytics use this book to understand what IT people are doing?

Rica

Hi Stefan, thanks for doing this. What type of securities does machine learning for algorithmic trading cover?

Rica

Can you share some success stories in using machine learning for algorithmic trading?

Rica

Last question: can machine learning for algorithmic trading detect or prevent what happened to Gamestop? Thank you for your time 🙂

Denis Lepchev

Hi Stefan, thanks for writing the book!
What in your opinion are most common pitfalls in backtesting and how to avoid them? To extend the previous question, what do you think about usage of synthetic data for backtesting - how reliable it is?Thank you.

Oliver Wilkins

Hi Stefan, it’d be great to see your thoughts on this!

Wendy Mak

Hi Stefan, my question is:
Does algorithmic trading (tbh all the ‘fancy’ financial instruments in general) serve any positive purpose beyond making a bunch of investment bankers very rich? ;)) – sorry it’s only distantly related to the main content in your book, but I’ve never really got the point of the fancier things you can do on the stock/commodities/etc markets…

Vladimir Finkelshtein

I imagine if one trains trading algorithms with neural networks, they will learn many spurious correlations. Is there some regularization for this?

Vladimir Finkelshtein

Once in a while there is an article about some academic algorithm that beats the market. But these algorithms always work only on the past data. Are there examples of ML algorithms that actually generalize to the future?
Is this question even meaningful? Since most of the trading today is algorithmic, maybe beating the market just means beating other algorithms?

Vladimir Finkelshtein

My statement about “most of the trading is algorithmic” refers to forex market (in which wiki says algo trading is 90%). You can disregard it, since it is probably not true for more volatile markets.

Tino

Hey Stefan! 👋 Thanks for sharing your knowledge! 🧠 How do you include the natural uncertainty when modelling stocks, trading, etc! Often individuals (Elon Musk, etc.) can have an unpredictable impact. Is there kind of a general approach to include this?

Arni Westh

Have you launched any algo trading systems trading live autonomously with real assets on the line? Imo, until this stage, all of these discussions tends to be rather academic - it’s when you go live you learn about all details you didn’t think about in simulation/backtesting…

Stefan Jansen

Alright, so here are a few points on your questions:

  1. On Aleix question of how I would describe the use of ML for trading in the industry:
    • Finance, of course, has very long history of using quantitative tools. This includes basic ML algos like good old linear regression.
    • Just as elsewhere, more data drives more demand for better techniques to apply to the data. More specifically, together with the emergence of ‘alternative data’ (https://alternativedata.org/), there has been a lot if interest (and more need) to use data science / ML to extract value.
    • This takes different forms depending on the time horizon:
      ◦ On one end of the spectrum, it includes more traditional investors that have started to use ML to forecast fundamentals (see e.g. interview with Michael Recce, now CDS at Neuberberger Berman who previously introduced this at Point 72: https://www.investmentmagazine.com.au/2019/10/michael-recce-the-goldilocks-approach-to-neuroscience-ai-and-investing/).
      ◦ On the other end, high-frequency trading also offers applications from optimal trade execution to alpha (see, e.g. survey of use cases: https://www.cis.upenn.edu/~mkearns/papers/KearnsNevmyvakaHFTRiskBooks.pdf).
    • The basic argument in favor of using ML is that most investors are already trying to project market trends in the short or long run from all sorts of data. It’s not unreasonable to assume that ML can add value to this process. Machines naturally have more of an edge for shorter horizons, whereas humans may be (still) better positioned to process the complex information involved in analyzing longer-term trends.
    • It is important to keep in mind that financial markets are highly competitive and packed with sophisticated institutions operating at substantial scale. Clearly it takes a bit more than downloading some data from yahoo finance and installing scikit-learn to predict Apple’s (or Tesla’s..) stock price. Some healthy skepticism is certainly warranted and several funds have closed down their ML efforts.
    • At the same time, you may have heard of Renaissance Technology (RenTek). I’d highly recommend ‘The man who solve the market’ about Jim Simons (https://www.amazon.com/Man-Who-Solved-Market-Revolution/dp/073521798X) who started the - by far! - most successful hedge fund, achieving 50%+ per year since the late 80s on their (now only internal) Medallion Fund. Earlier and more focused than most, Rentek has built a highly-secretive quantitative fund run largely by scientists who have started collecting huge datasets before anybody else was doing this, and apply all sorts of proprietary algorithms to identify patterns. While nobody knows what they are actually doing, much would probably be broadly classified as ML that operates in a largerly autonomous fashion.
    • Two Sigma, started by DE Shaw alums who also hired several ML & Python specialists (Anaconda provides consultancy, lead Pandas maintainer is VP). These are very substantial success stories, and have attracted numerous attempts to imitate with mixed results.
    • However, financial markets are very large and diverse, extending way beyond the (recently) popular sensations surrounding Gamestop, Tesla or Bitcoin. There are many niches in less actively traded areas where even smaller players can do well.
Rica

I’m curious has Rentek ever publish about its models?

nate8020

What a high-quality response Stefan. This alone has made me infinitely curious about your work.

Aleix

man, that’s what I call a response! thanks a lot for the huge details and clarity, really appreaciated!

Stefan Jansen

Rica nothing, nada, niente. airtight NDAs. the book is really fun to read, you’ll see. the folks who work there are as good as it gets.

Doink

why is alternativedata giving their datasets for free?

Stefan Jansen

On market manipulation: it’s hard to know. Manipulation is illegal and regulators are watching. Not sure predicting returns better than by chance which is already useful would count as or be confounded with market manipulation. I would also distinguish between the famous Elon Musk etc examples and the much larger volume that trades in less spectacular environments. Since I’m not sure that the bulk of trading activity is related to market manipulation, I’m not sure ML would automatically ‘learn how to do it’. Also, manipulation typically requires some influence - either the ML would first have to figure out how to attract as many twitter followers and general real world success as Elon Musk, or how to rally a bunch of reddit users (plus the HF that also played along). Tricky..

Stefan Jansen

Hong-Ngoc Emily Tran - who should read the book: it’s useful if you’re an analyst who wants to go beyond spreadsheet, a PM who wants to use ML, either to run things herself or by directing specialists. The book is fairly hands-on with 150+ notebooks; you should be pretty familiar with Python and the standard data science/ML libraries so you can focus on the domain-specific aspects.

Stefan Jansen

Rica the book mostly uses equities simply because the data is most easily available. Free data is rare, but we do have examples that use minute-data (somewhat ‘high-frequency’) as well as intl equities and pairs trading with ETF. I would say though, that the most important part is demonstrating how the ML algorithms can be used to inform a strategy and then backtest/evaluate the strategy. I think if you’re proficient with these applications you’re in a very good position to come up with your own ideas for other markets if you prefer.

Rica

Thanks for your response Stefan Jansen, I will explore and learn from your models 🙂

Stefan Jansen

Denis Lepchev backtesting is tricky as you’ve probably hear. I’m sure you’ve come across Marcos Lopez de Prado who is one of the leading practitioners in the field and has discussed this in great detail (now runs quant at Abu Dhabi’s SWF, before at Guggenheim and AQR https://www.quantresearch.org/). My book summarizes his points which are conceptually simple: given limited historical data, if you just try long enough you’re bound to find something that looks really good in hindsight. Just like ML model overfitting. There are ways to protect against this, being aware of the risk being the first and most important step.
Synthetic data would be (part of ) a solution and and there are certainly promising early research results. In the book, I reproduce the TimeGAN paper presented recentat NeurIPS https://proceedings.neurips.cc/paper/2019/file/c9efe5f26cd17ba6216bbe2a7d26d490-Paper.pdf. I haven’t had the time to experiment with this at scale but I’m sure most of the larger funds are exploring this as an option. It may take a few years until we know if this can produce sufficiently useful data; GANs have the mode collapse problem that delivers very realistic but not very diverse results, which is one of the issues that still needs to be overcome.

nate8020

Marco’s work is high-caliber, this fragment of his book (Advances in Financial Machine Learning / Marcos Lopez de Prado) really grabbed my attention when his book came out.

Stefan Jansen

Wendy Mak good and fair question. I would agree that the financial sector has overall taken on proportions as a % of GDP that is quite a bit larger than its contribution to overall welfare. There are some economic arguments how sophisticated investors make markets more efficient because they help ‘discover the right prices’ that are signals for other activity, but I’m not sure that justifies the outsized gains by some. Applies to other areas as well, though; I’m not sure the winner-take-all results in some industries are the best outcome overall.

Stefan Jansen

Vladimir Finkelshtein right, financial data is very noisy, precisely because markets are a competitive arena to the extent that quite a few say it should be next to impossible to predict anything about price movements at all. The best way out is of course access to (at least somewhat) exclusive data. Even then, and even more so if you rely mostly on market data, denoising via feature engineering (we cover e.g. Kalman filter etc) and regularlzation are key. In fact, complex models like deep NN are often at a disadvantage since they cannot benefit from the abundance of data that we have in other domains where they excel. In other words, success is unlikely going to rely on the biggest model but rather on a good overall setup from good data to robust risk and transaction cost management.

Stefan Jansen

Tino ML models perform best when there’s a systematic relationship between the input data and the target. They are least likely to do well when things fundamentally change. Fortunately, the Gamestop & Musk stories are not what dominates markets, just the news. So there’s plenty of room for models to add value (I think..).

Stefan Jansen

Arni Westh fair point, the book on Simons/Rentek in fact has some of the key figures of the fund on record that the one thing that never worked was trying to replicate academic papers. I work with clients and there are some examples in the wild that are working. It’s often based on a strategy that uses some specific data and has been developed manually before (and already created profits). ML is very useful to then automate and scale such a strategy. There are many use cases, just as there are many profitable traders that operate at limited scale, ‘under the radar’.

nate8020

Stefan Jansen in your view, where is the greatest opportunity at the intersection of ML and Algo-Trading right now?

Vinoth Kumar

Hi Stefan Jansen .

  1. From your experience in developing ML systems for trading, what are the characteristics of a simple system and when does it become too complex. And do simple systems do Better than complex systems.
  2. Retail investors have certain advantages over institutional investors in terms of size. How can retailers develop systems that play to their advantage over the big funds houses.
  3. trading Systems also need to be aligned with the over market- bull, bear and side ways market. How can investors predict the future state of market or when they should fine tune their allocation to various systems.
  4. What are some of the features that retailers usually miss in their trading systems design.
Amr Alaa

Hey Stefan Jansen, thanks for your answers here,
Can python developer or machine learning engineer benefit from your awesome book, or donwe need to review some of the basics first?

Amr Alaa

2nd question
Why it is so hard to get excellent results with ML in trading systems
We can develop reinforcement learning to deal with the market using paper money for 6 months, it will had most of the parameters needed to do good profitting trades after using real accounts, right?
I know it looks pretty silly, but why it is not working like this using modern learning techniques?

Tino

Hey Stefan Jansen :) thanks for the great answer :)
A follow-up question: depending on volatility and risk which varies from market to market, how would you rate the options for risk distribution over ones portfolio by using ML? And is this e.g. a more suitable/accurate use case?

Vladimir Finkelshtein

From your answers it sounds like that the industry prefers to rely on the advanced features engineered by domain experts and to apply less complex and reliable algorithms. Is there a hope that ML can find insights unknown to the experts? It seems like there are many regulatory and trust-related problems to use the latent features that ML offers in other domains.

Stefan Jansen

Vladimir Finkelshtein when it comes to financial data, esp market data (prices, volumes, returns), there is a lot of noise and complex models tend to overfit plus some domain expertise has developed over the last decades when this was the only data (plus fundamentals). What’s new is that now much more data is available - from new to credit card payments, mobile phone location or supplier activity. In this sense, finance is catching up to other industries and the evaluation of what works and what doesn’t is still underway. Clearly there are regulatory issues around privacy and also fair competition, which are also still playing out.

Stefan Jansen

nate8020 not sure there is one single greatest opportunity. There are several that range from -

  • coming up with ingenuous use cases of novel datasets to
  • NLP applications (given advances in the area and the limited use of text data thus far) and
  • using ML/DL in low-latency context
Stefan Jansen

Vinoth Kumar

  • The system should match the kind of data and scale you’re operating at. If you properly test your models you should notice pretty quickly when they over- or underfit. I don’t think there’s a general rule, it really depends on what you are trying you accomplish.
  • Clearly, the most profitable hedge funds that use ML also operate at scale in terms of AUM, staff, data and range of different strategies. Your best chance as a retail investor is to find a niche that you know or are learning something about that has not attracted too many sophisticated players yet. I’m not sure it’s ‘the system’ as more the area you choose to play.
  • Overall market trends is a macro prediction that retail investors can do as well (or poorly) as anyone else. It’s hard! But gotta keep trying 🙂
  • Retail investors may want neglect to have a nimble system that permits them to constantly come up with new ideas and migrate them from backtest to paper- and then livetrading, while closely monitoring the latter. It’s always evolving.
Stefan Jansen

Tino there are attempts to use hiearchical clustering and others to handle asset/risk allocation, see Lopez de Prado 2016: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2708678
Some results are promising, others not so much. Certainly some research in this direction.

Tino

Stefan Jansen thanks for the answer :)

Stefan Jansen

Amr Alaa if you’re familiar with python & ML using pandas/sklearn/tensorflow you should be fine and off to the races.

  • It’s hard because markets are very competitive. See previous answers.
  • Think about how trading works - for me to make money, someone else tends to lose some. There’s a lot of smart people at works because there’s a lot of money to be made. That’s why it’s hard. Market players adapt very quickly to changes in the market, news etc.
Wendy Mak

Hi Stefan, if I am not particularly interested in apply the algos to real trading, do you think the concepts introduced in your book still quite useful for other ML applications? e.g. I think you said there are some interesting timeseries algos you introduced in the book?

Amr Alaa

Great question by the way

Stefan Jansen

Wendy Mak I try to give a fairly broad overview of ML with plenty of background on how things work. Some have found it useful as a more general reference but really depends on your interests and background. Check out the website https://www.ml4trading.io/ and the repo https://github.com/stefan-jansen/machine-learning-for-trading where you can see in detail what to expect.

nate8020

Stefan Jansen Say you set aside $100 (of real USD) of budget to build your own trading bot, what would be a good resource to put together such home-built service (APIs)?

Stefan Jansen

nate8020 not sure I understand, what would you spend the $100 on? Data, services, investment capital, learning reources?

nate8020

Say I want to create my own trading bot with real money ($100). Is there a public API I can use to actually execute trades and pull balances? You know, like the pros 🙂

nate8020

Stefan Jansen this is what I was looking for: https://algotrading101.com/learn/robinhood-api-guide/

Stefan Jansen

Oh sorry didn’t see your clarification. There’s also Alpaca; IB also has a popular API.

Stefan Jansen

The plan for the 3rd edition is to include the trading/execution part. If time permits..

nate8020

You’ve got your first sale ready! 😁

Dan

As someone who has read Stefan Jansen’s book thoroughly (https://www.linkedin.com/feed/update/urn:li:activity:6712046823361536000/) I can tell you that this book is fantastic.
Not only for trading and finance but ML and data science in general. It went brilliantly in tandem with my MS in Financial Math. It’s brilliant how it explains really complicated concept in easy to grasp chunks.
People like to compare this book to Marcos Lopez de Prado’s book but they’re not really a competition, I’d say they work in tandem. Furthermore this is the more technical one and with better applications.
MLDP’s is more general concepts and most of the code examples are from python 2. Not taking anything away from his books, they’re brilliant, but Stefan Jansen’s is definitely more up-to-date
Could not possibly recommend this book enough.

Vladimir Finkelshtein

What is the current hype in algorithmic trading and is it justified or not in your opinion? I heard people got excited about LSTMs but that was a while ago.

Stefan Jansen

Thanks Dan! Absolutely, I would not in my dreams attempt to compete with Marcos Lopez de Prado; I think we have very different goals. Adv. in Fin ML is a collection of research and practical advice from a leading practitioner and first and foremost delivers some very pointed insights straight from the frontier. I’m trying to provide a much broader introduction and think it is best read as a domain-specific intro to ML. I’ve done both trading and data science for while and when I was teaching DS in NYC I noticed that there was a lot of interest from folks in investment but hardly any specific material available. Personally I think it’s helpful to have a good grasp of how algos work I have included quite a bit of background and that’s possibly why I’ve heard a few times that folks have got something out of it about using ML more generally, esp in a time series context.

Stefan Jansen

Vladimir Finkelshtein I guess hype is almost by definition not justified? I think it’s a case of overestimated in the short run, underestimated in the long run. It takes time to figure out how to incorporate ML into trading processes since it’s not about switching over from human to machine in most cases; finding the right balance is a bit of work that takes many years. I’m sure in 10 years ML and the use of a very broad range of data is going to be common place. May look different than we imagine today but I think it’s hard to see that crunching excel is going to grow and python & co will disappear instead.

tony hung

Hey Stefan Jansen Im currently working on a forecasting model and I’m curious if the book goes into detail about ARIMA and othe r deep Learning models. I don’t know much about finance ,and more on the deep Learning side. Is the book geared towards finance people or ml people? I’m hoping both

Stefan Jansen

hey tony hung the book tries to sort of bridge the gap. there’s a chapter on arima, arch/garch and cointegration, and another one on RNN. and of course much more, check out the website and repo linked a bit above that should give you an idea

tony hung

Thanks, I’m going through the site now

Stefan Jansen

Great, pls let me know what you think!

Vladimir Finkelshtein

What are some other use cases of ML in algorithmic trading beyond traders making profit? (I am thinking of regulators here, but maybe something else?)

Doink

Stefan Jansen how to detect pump and dump characteristics in a stock? And to spot parties which create FUD? Do you think Renaissance Finance or Two Sigma handle this? I had seen a kaggle competition of 2 sigma where they tried to do sentiment analysis of stocks via news but they removed that data.

Roman G

I’ve heard a story about a system which detects insider trading at NASDAQ, which tries to estimate via ML how lucky you are. If you are too lucky, then a person in SEC takes a detailed look on your trading activity 🙂

Doink

Interesting stuff but how can you build such a system?

Vladimir Finkelshtein

That almost sounds like rule based approach: if you are making higher margins than others (in some metric), you will be looked at closely.

nate8020

Roman G Vladimir Finkelshtein do you know of an API in which I can place but/sell trades? I wanna play with the algos of the book with an actual (tiny) budget

Vladimir Finkelshtein

Not really.

Roman G

it depends on your scale. HFT traders usually use FIX apis to directly inject orders into broker system, but these are usually quite pricey: expect somewhere around 1-2k$/month + comissions.

Roman G

a low-cost solution can be using brokers public apis like this: https://www.interactivebrokers.com/en/index.php?f=5041

Roman G

these APIs won’t give you ultra-low-latency, but it’s cheap enough to play with it.

Roman G

main pro of FIX is that you’re not tied to a specific broker and migrate freely. main con is that it’s quite complicated (market data tier2 stream for NASDAQ has so huge data rate so it’s non-trivial even to receive it)

Chris Chia

Hi Stefan, thanks for writing the book! Are there any recent papers or new ML/DL techniques that are still emerging, but you think could be particularly promising towards algorithmic trading?

Stefan Jansen

Vladimir Finkelshtein regulators would be interested in market manipulation through collusion, cornering or things like insider trading . methods like anomaly detection come to mind. here’s the SEC on the topic: https://www.sec.gov/news/speech/bauguess-big-data-ai

Stefan Jansen

Doink for traders, detecting such schemes would be useful if they can profit from it. as such they would be looking for profitable momentum situations based on volume velocity and who is participating. regulators might be more interested in detecting such a scheme as and end to itself rather than a means to profit. they are certainly trying.

Stefan Jansen

Roman G see above - not familiar with this story but clearly if your trades turn a profit too many times you’ll raise flags just like in a casino.

Stefan Jansen

Chris Chia the book has tons of references, many of a recent nature. look up bryan kelly at yale/aqr, for instance who has been pretty active, and the work he and co-authors cite.

Tino

Stefan Jansen Is explainabilty a Big topic in trading? In credit risk for e.g. it is super important due to reportings for the regulator. Is it similar in trading?

Stefan Jansen

Tino the datasets themselves are certainly subjects to compliance re privacy etc. On the modeling side, I think explainability is more of an issue because decision makers (depending on the organization) want to understand if a model aligns with their priors than for the reasons you mention for credit decisions, for instance. It’s certainly a hot topic, but getting the models to work well is probably a higher priority.

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