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Machine Learning For Trading

Machine learning (ML) algorithms are increasingly used in algorithmic trading to automate trading strategies and enhance decision-making by analyzing market data. The primary goal of active investment management is to achieve alpha, or returns exceeding a benchmark, which relies on accurate forecasting and effective use of information. This chapter explores the broader impact of ML on various investment activities, highlighting its role as a competitive advantage in the industry.

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9 views2 pages

Machine Learning For Trading

Machine learning (ML) algorithms are increasingly used in algorithmic trading to automate trading strategies and enhance decision-making by analyzing market data. The primary goal of active investment management is to achieve alpha, or returns exceeding a benchmark, which relies on accurate forecasting and effective use of information. This chapter explores the broader impact of ML on various investment activities, highlighting its role as a competitive advantage in the industry.

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Machine Learning for

Trading
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.

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.

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.

Hence, the key to generating alpha is forecasting. Successful


predictions, in turn, require superior information or a superior
ability to process public information. Algorithms facilitate
optimization throughout the investment process, from asset
allocation to idea-generation, trade execution, and risk
management. 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.

Historically, algorithmic trading used to be more narrowly


defined as the automation of trade execution to minimize costs
as offered by the sell side, but we will take a more
comprehensive perspective since the use of algorithms, and
ML, in particular, has come to impact a broader range of
activities from idea generation and alpha factor design to asset
allocation, position sizing, and the testing and evaluation of
strategies.

This chapter looks at the bigger picture of how the use of ML


has emerged as a critical source of competitive advantage in
the investment industry and where it fits into the investment
process to enable algorithmic trading strategies.

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