Sunday, October 10, 2010

Data mining and artificial intelligence update

Long time readers of this blog know that I haven't found data mining or artificial intelligence techniques to be very useful for my own trading, for they typically overfit to non-recurring past patterns. (Not surprisingly, they are much more useful for driverless cars.) Nevertheless, one must keep an open mind and continues to keep tabs on new developments in this field.

To this end, here is a new paper written by an engineering student at UC Berkeley which uses "support
vector machine" together with 10 simple technical indicators to predict the SPX index, purportedly with 60% accuracy. If one includes an additional indicator which measures the number of news articles on a stock in the previous day, then the accuracy supposedly goes up to 70%.

I did not have the chance to reproduce and verify this result yet, but I invite you to try it out and share your findings here. If you do so, you may find this new data mining product called 11Ants Analytics useful. It is an Excel-based software that includes 11 machine learning algorithms including the aforementioned support vector machines. It also includes decision trees which are sometimes quite useful in automatically generating a small set of trading rules from an input set of technical indicators. (Whether those rules remain profitable in the future is another question!) If you have tried this product, I would also appreciate your comments here.

(If you are a die-hard MATLAB fan, support vector machines are available in their Bioinformatics Toolbox, and classification and decision trees in their Statistics Toolbox.)

Saturday, October 02, 2010

The main virtue of buying options

I realized that I have omitted the most obvious virtue of trading options instead of stocks in my last post: the much more attractive reward-risk ratio for options.

Suppose your stock strategy generated a buy signal. You can either buy the stock now, or you can buy an ATM call. If you buy the stock, you are of course benefiting from 100% of the upside potential of the stock price movement, but you are similarly exposed to 100% of the downside risk. Indeed you can lose the entire market value of the stock. If you buy the call, you will benefit from > 50% of the upside potential of the stock price, assuming that your holding period is so short that the time value will not dissipate much. As the stock price rises, so does your delta. (It increases from 0.5 to 1.) But what about the downside risk? All you can lose is the option premium, usually << 50% of the market value of the stock.

In other words, while one may be tempted to hedge a large stock position with stock index futures, there is no need to hedge an equivalent call option position. This should simplify your strategy implementation and reduce risk management costs (i.e. the probable loss on your short futures position).

Given that I am a short-term trader anyway, I can't figure out why I have been trading stocks instead of options all these years! (Aside from the caveats detailed in the previous post.)