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Overview
Machine learning (ML) is changing virtually every aspect of our lives. Today, ML algorithms accomplish tasks that – until recently – only expert humans could perform. And finance is ripe for disruptive innovations that will transform how the following generations understand money and invest.
In the book, readers will learn how to:
- Structure big data in a way that is amenable to ML algorithms
- Conduct research with ML algorithms on big data
- Use supercomputing methods and back test their discoveries while avoiding false positives
Advances in Financial Machine Learning addresses real life problems faced by practitioners every day, and explains scientifically sound solutions using math, supported by code and examples. Readers become active users who can test the proposed solutions in their individual setting.
Written by a recognized expert and portfolio manager, this book will equip investment professionals with the groundbreaking tools needed to succeed in modern finance.
Product Details
| ISBN-13: | 9781119482109 |
|---|---|
| Publisher: | Wiley |
| Publication date: | 02/02/2018 |
| Sold by: | JOHN WILEY & SONS |
| Format: | eBook |
| Pages: | 400 |
| Sales rank: | 434,256 |
| File size: | 15 MB |
| Note: | This product may take a few minutes to download. |
About the Author
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Table of Contents
About the Author xxiPREAMBLE 1
1 Financial Machine Learning as a Distinct Subject 3
1.1 Motivation, 3
1.2 The Main Reason Financial Machine Learning Projects Usually Fail, 4
1.2.1 The Sisyphus Paradigm, 4
1.2.2 The Meta-Strategy Paradigm, 5
1.3 Book Structure, 6
1.3.1 Structure by Production Chain, 6
1.3.2 Structure by Strategy Component, 9
1.3.3 Structure by Common Pitfall, 12
1.4 Target Audience, 12
1.5 Requisites, 13
1.6 FAQs, 14
1.7 Acknowledgments, 18
Exercises, 19
References, 20
Bibliography, 20
Part 1 Data Analysis 21
2 Financial Data Structures 23
2.1 Motivation, 23
2.2 Essential Types of Financial Data, 23
2.2.1 Fundamental Data, 23
2.2.2 Market Data, 24
2.2.3 Analytics, 25
2.2.4 Alternative Data, 25
2.3 Bars, 25
2.3.1 Standard Bars, 26
2.3.2 Information-Driven Bars, 29
2.4 Dealing with Multi-Product Series, 32
2.4.1 The ETF Trick, 33
2.4.2 PCA Weights, 35
2.4.3 Single Future Roll, 36
2.5 Sampling Features, 38
2.5.1 Sampling for Reduction, 38
2.5.2 Event-Based Sampling, 38
Exercises, 40
References, 41
3 Labeling 43
3.1 Motivation, 43
3.2 The Fixed-Time Horizon Method, 43
3.3 Computing Dynamic Thresholds, 44
3.4 The Triple-Barrier Method, 45
3.5 Learning Side and Size, 48
3.6 Meta-Labeling, 50
3.7 How to Use Meta-Labeling, 51
3.8 The Quantamental Way, 53
3.9 Dropping Unnecessary Labels, 54
Exercises, 55
Bibliography, 56
4 Sample Weights 59
4.1 Motivation, 59
4.2 Overlapping Outcomes, 59
4.3 Number of Concurrent Labels, 60
4.4 Average Uniqueness of a Label, 61
4.5 Bagging Classifiers and Uniqueness, 62
4.5.1 Sequential Bootstrap, 63
4.5.2 Implementation of Sequential Bootstrap, 64
4.5.3 A Numerical Example, 65
4.5.4 Monte Carlo Experiments, 66
4.6 Return Attribution, 68
4.7 Time Decay, 70
4.8 Class Weights, 71
Exercises, 72
References, 73
Bibliography, 73
5 Fractionally Differentiated Features 75
5.1 Motivation, 75
5.2 The Stationarity vs. Memory Dilemma, 75
5.3 Literature Review, 76
5.4 The Method, 77
5.4.1 Long Memory, 77
5.4.2 Iterative Estimation, 78
5.4.3 Convergence, 80
5.5 Implementation, 80
5.5.1 Expanding Window, 80
5.5.2 Fixed-Width Window Fracdiff, 82
5.6 Stationarity with Maximum Memory Preservation, 84
5.7 Conclusion, 88
Exercises, 88
References, 89
Bibliography, 89
Part 2 Modelling 91
6 Ensemble Methods 93
6.1 Motivation, 93
6.2 The Three Sources of Errors, 93
6.3 Bootstrap Aggregation, 94
6.3.1 Variance Reduction, 94
6.3.2 Improved Accuracy, 96
6.3.3 Observation Redundancy, 97
6.4 Random Forest, 98
6.5 Boosting, 99
6.6 Bagging vs. Boosting in Finance, 100
6.7 Bagging for Scalability, 101
Exercises, 101
References, 102
Bibliography, 102
7 Cross-Validation in Finance 103
7.1 Motivation, 103
7.2 The Goal of Cross-Validation, 103
7.3 Why K-Fold CV Fails in Finance, 104
7.4 A Solution: Purged K-Fold CV, 105
7.4.1 Purging the Training Set, 105
7.4.2 Embargo, 107
7.4.3 The Purged K-Fold Class, 108
7.5 Bugs in Sklearn’s Cross-Validation, 109
Exercises, 110
Bibliography, 111
8 Feature Importance 113
8.1 Motivation, 113
8.2 The Importance of Feature Importance, 113
8.3 Feature Importance with Substitution Effects, 114
8.3.1 Mean Decrease Impurity, 114
8.3.2 Mean Decrease Accuracy, 116
8.4 Feature Importance without Substitution Effects, 117
8.4.1 Single Feature Importance, 117
8.4.2 Orthogonal Features, 118
8.5 Parallelized vs. Stacked Feature Importance, 121
8.6 Experiments with Synthetic Data, 122
Exercises, 127
References, 127
9 Hyper-Parameter Tuning with Cross-Validation 129
9.1 Motivation, 129
9.2 Grid Search Cross-Validation, 129
9.3 Randomized Search Cross-Validation, 131
9.3.1 Log-Uniform Distribution, 132
9.4 Scoring and Hyper-parameter Tuning, 134
Exercises, 135
References, 136
Bibliography, 137
Part 3 Backtesting 139
10 Bet Sizing 141
10.1 Motivation, 141
10.2 Strategy-Independent Bet Sizing Approaches, 141
10.3 Bet Sizing from Predicted Probabilities, 142
10.4 Averaging Active Bets, 144
10.5 Size Discretization, 144
10.6 Dynamic Bet Sizes and Limit Prices, 145
Exercises, 148
References, 149
Bibliography, 149
11 The Dangers of Backtesting 151
11.1 Motivation, 151
11.2 Mission Impossible: The Flawless Backtest, 151
11.3 Even If Your Backtest Is Flawless, It Is Probably Wrong, 152
11.4 Backtesting Is Not a Research Tool, 153
11.5 A Few General Recommendations, 153
11.6 Strategy Selection, 155
Exercises, 158
References, 158
Bibliography, 159
12 Backtesting through Cross-Validation 161
12.1 Motivation, 161
12.2 The Walk-Forward Method, 161
12.2.1 Pitfalls of the Walk-Forward Method, 162
12.3 The Cross-Validation Method, 162
12.4 The Combinatorial Purged Cross-Validation Method, 163
12.4.1 Combinatorial Splits, 164
12.4.2 The Combinatorial Purged Cross-Validation Backtesting Algorithm, 165
12.4.3 A Few Examples, 165
12.5 How Combinatorial Purged Cross-Validation Addresses Backtest Overfitting, 166
Exercises, 167
References, 168
13 Backtesting on Synthetic Data 169
13.1 Motivation, 169
13.2 Trading Rules, 169
13.3 The Problem, 170
13.4 Our Framework, 172
13.5 Numerical Determination of Optimal Trading Rules, 173
13.5.1 The Algorithm, 173
13.5.2 Implementation, 174
13.6 Experimental Results, 176
13.6.1 Cases with Zero Long-Run Equilibrium, 177
13.6.2 Cases with Positive Long-Run Equilibrium, 180
13.6.3 Cases with Negative Long-Run Equilibrium, 182
13.7 Conclusion, 192
Exercises, 192
References, 193
14 Backtest Statistics 195
14.1 Motivation, 195
14.2 Types of Backtest Statistics, 195
14.3 General Characteristics, 196
14.4 Performance, 198
14.4.1 Time-Weighted Rate of Return, 198
14.5 Runs, 199
14.5.1 Returns Concentration, 199
14.5.2 Drawdown and Time under Water, 201
14.5.3 Runs Statistics for Performance Evaluation, 201
14.6 Implementation Shortfall, 202
14.7 Efficiency, 203
14.7.1 The Sharpe Ratio, 203
14.7.2 The Probabilistic Sharpe Ratio, 203
14.7.3 The Deflated Sharpe Ratio, 204
14.7.4 Efficiency Statistics, 205
14.8 Classification Scores, 206
14.9 Attribution, 207
Exercises, 208
References, 209
Bibliography, 209
15 Understanding Strategy Risk 211
15.1 Motivation, 211
15.2 Symmetric Payouts, 211
15.3 Asymmetric Payouts, 213
15.4 The Probability of Strategy Failure, 216
15.4.1 Algorithm, 217
15.4.2 Implementation, 217
Exercises, 219
References, 220
16 Machine Learning Asset Allocation 221
16.1 Motivation, 221
16.2 The Problem with Convex Portfolio Optimization, 221
16.3 Markowitz’s Curse, 222
16.4 From Geometric to Hierarchical Relationships, 223
16.4.1 Tree Clustering, 224
16.4.2 Quasi-Diagonalization, 229
16.4.3 Recursive Bisection, 229
16.5 A Numerical Example, 231
16.6 Out-of-Sample Monte Carlo Simulations, 234
16.7 Further Research, 236
16.8 Conclusion, 238
Appendices, 239
16.A.1 Correlation-based Metric, 239
16.A.2 Inverse Variance Allocation, 239
16.A.3 Reproducing the Numerical Example, 240
16.A.4 Reproducing the Monte Carlo Experiment, 242
Exercises, 244
References, 245
Part 4 Useful Financial Features 247
17 Structural Breaks 249
17.1 Motivation, 249
17.2 Types of Structural Break Tests, 249
17.3 CUSUM Tests, 250
17.3.1 Brown-Durbin-Evans CUSUM Test on Recursive Residuals, 250
17.3.2 Chu-Stinchcombe-White CUSUM Test on Levels, 251
17.4 Explosiveness Tests, 251
17.4.1 Chow-Type Dickey-Fuller Test, 251
17.4.2 Supremum Augmented Dickey-Fuller, 252
17.4.3 Sub- and Super-Martingale Tests, 259
Exercises, 261
References, 261
18 Entropy Features 263
18.1 Motivation, 263
18.2 Shannon’s Entropy, 263
18.3 The Plug-in (or Maximum Likelihood) Estimator, 264
18.4 Lempel-Ziv Estimators, 265
18.5 Encoding Schemes, 269
18.5.1 Binary Encoding, 270
18.5.2 Quantile Encoding, 270
18.5.3 Sigma Encoding, 270
18.6 Entropy of a Gaussian Process, 271
18.7 Entropy and the Generalized Mean, 271
18.8 A Few Financial Applications of Entropy, 275
18.8.1 Market Efficiency, 275
18.8.2 Maximum Entropy Generation, 275
18.8.3 Portfolio Concentration, 275
18.8.4 Market Microstructure, 276
Exercises, 277
References, 278
Bibliography, 279
19 Microstructural Features 281
19.1 Motivation, 281
19.2 Review of the Literature, 281
19.3 First Generation: Price Sequences, 282
19.3.1 The Tick Rule, 282
19.3.2 The Roll Model, 282
19.3.3 High-Low Volatility Estimator, 283
19.3.4 Corwin and Schultz, 284
19.4 Second Generation: Strategic Trade Models, 286
19.4.1 Kyle’s Lambda, 286
19.4.2 Amihud’s Lambda, 288
19.4.3 Hasbrouck’s Lambda, 289
19.5 Third Generation: Sequential Trade Models, 290
19.5.1 Probability of Information-based Trading, 290
19.5.2 Volume-Synchronized Probability of Informed Trading, 292
19.6 Additional Features from Microstructural Datasets, 293
19.6.1 Distibution of Order Sizes, 293
19.6.2 Cancellation Rates, Limit Orders, Market Orders, 293
19.6.3 Time-Weighted Average Price Execution Algorithms, 294
19.6.4 Options Markets, 295
19.6.5 Serial Correlation of Signed Order Flow, 295
19.7 What Is Microstructural Information?, 295
Exercises, 296
References, 298
Part 5 High-performance Computing Recipes 301
20 Multiprocessing and Vectorization 303
20.1 Motivation, 303
20.2 Vectorization Example, 303
20.3 Single-Thread vs. Multithreading vs. Multiprocessing, 304
20.4 Atoms and Molecules, 306
20.4.1 Linear Partitions, 306
20.4.2 Two-Nested Loops Partitions, 307
20.5 Multiprocessing Engines, 309
20.5.1 Preparing the Jobs, 309
20.5.2 Asynchronous Calls, 311
20.5.3 Unwrapping the Callback, 312
20.5.4 Pickle/Unpickle Objects, 313
20.5.5 Output Reduction, 313
20.6 Multiprocessing Example, 315
Exercises, 316
Reference, 317
Bibliography, 317
21 Brute Force and Quantum Computers 319
21.1 Motivation, 319
21.2 Combinatorial Optimization, 319
21.3 The Objective Function, 320
21.4 The Problem, 321
21.5 An Integer Optimization Approach, 321
21.5.1 Pigeonhole Partitions, 321
21.5.2 Feasible Static Solutions, 323
21.5.3 Evaluating Trajectories, 323
21.6 A Numerical Example, 325
21.6.1 Random Matrices, 325
21.6.2 Static Solution, 326
21.6.3 Dynamic Solution, 327
Exercises, 327
References, 328
22 High-Performance Computational Intelligence and Forecasting Technologies 329 Kesheng Wu and Horst D. Simon
22.1 Motivation, 329
22.2 Regulatory Response to the Flash Crash of 2010, 329
22.3 Background, 330
22.4 HPC Hardware, 331
22.5 HPC Software, 335
22.5.1 Message Passing Interface, 335
22.5.2 Hierarchical Data Format 5, 336
22.5.3 In Situ Processing, 336
22.5.4 Convergence, 337
22.6 Use Cases, 337
22.6.1 Supernova Hunting, 337
22.6.2 Blobs in Fusion Plasma, 338
22.6.3 Intraday Peak Electricity Usage, 340
22.6.4 The Flash Crash of 2010, 341
22.6.5 Volume-synchronized Probability of Informed Trading Calibration, 346
22.6.6 Revealing High Frequency Events with Non-uniform Fast Fourier Transform, 347
22.7 Summary and Call for Participation, 349
22.8 Acknowledgments, 350
References, 350
Index 353
What People are Saying About This
"In his new book Advances in Financial Machine Learning, noted financial scholar Marcos López de Prado strikes a well-aimed karate chop at the naive and often statistically overfit techniques that are so prevalent in the financial world today. He points out that not only are business-as-usual approaches largely impotent in today's high-tech finance, but in many cases they are actually prone to lose money. But López de Prado does more than just expose the mathematical and statistical sins of the finance world. Instead, he offers a technically sound roadmap for finance professionals to join the wave of machine learning. What is particularly refreshing is the author's empirical approach — his focus is on real-world data analysis, not on purely theoretical methods that may look pretty on paper but which in many cases are largely ineffective in practice. The book is geared to finance professionals who are already familiar with statistical data analysis techniques, but it is well worth the effort for those who want to do real state-of-the-art work in the field."—Dr. David H. Bailey, former Complex Systems Lead, Lawrence Berkeley National Laboratory. Co-discoverer of the BBP spigot algorithm
"Finance has evolved from a compendium of heuristics based on historical financial statements to a highly sophisticated scientific discipline relying on computer farms to analyze massive data streams in real time. The recent highly impressive advances in machine learning (ML) are fraught with both promise and peril when applied to modern finance. While finance offers up the non-linearities and large data sets upon which ML thrives, it also offers up noisy data and the human element which presently lie beyond the scope of standard ML techniques. To err is human but if you really want to f**k things up, use a computer. Against this background, Dr. López de Prado has written the first comprehensive book describing the application of modern ML to financial modeling. The book blends the latest technological developments in ML with critical life lessons learned from the author's decades of financial experience in leading academic and industrial institutions. I highly recommend this exciting book to both prospective students of financial ML and the professors and supervisors who teach and guide them."—Prof. Peter Carr, Chair of the Finance and Risk Engineering Department, NYU Tandon School of Engineering
"Marcos is a visionary who works tirelessly to advance the finance field. His writing is comprehensive and masterfully connects the theory to the application. It is not often you find a book that can cross that divide. This book is an essential read for both practitioners and technologists working on solutions for the investment community."—Landon Downs, President and co-Founder, 1QBit
"Academics who want to understand modern investment management need to read this book. In it, Marcos Lopez de Prado explains how portfolio managers use machine learning to derive, test and employ trading strategies. He does this from a very unusual combination of an academic perspective and extensive experience in industry allowing him to both explain in detail what happens in industry and to explain how it works. I suspect that some readers will find parts of the book that they do not understand or that they disagree with, but everyone interested in understanding the application of machine learning to finance will benefit from reading this book."—Prof. David Easley, Cornell University. Chair of the NASDAQ-OMX Economic Advisory Board
"For many decades, finance has relied on overly simplistic statistical techniques to identify patterns in data. Machine learning promises to change that by allowing researchers to use modern non-linear and highly-dimensional techniques, similar to those used in scientific fields like DNA analysis and astrophysics. At the same time, applying those machine learning algorithms to model financial problems would be dangerous. Financial problems require very distinct machine learning solutions. Dr. López de Prado's book is the first one to characterize what makes standard machine learning tools fail when applied to the field of finance, and the first one to provide practical solutions to unique challenges faced by asset managers. Everyone who wants to understand the future of finance should read this book."—Prof. Frank Fabozzi, EDHEC Business School. Editor of The Journal of Portfolio Management
"This is a welcome departure from the knowledge hoarding that plagues quantitative finance. López de Prado defines for all readers the next era of finance: industrial scale scientific research powered by machines."—John Fawcett, Founder and CEO, Quantopian
"Marcos has assembled in one place an invaluable set of lessons and techniques for practitioners seeking to deploy machine learning techniques in finance. If machine learning is a new and potentially powerful weapon in the arsenal of quantitative finance, Marcos' insightful book is laden with useful advice to help keep a curious practitioner from going down any number of blind alleys, or shooting oneself in the foot."—Ross Garon, Head of Cubist Systematic Strategies. Managing Director, Point72 Asset Management
"The first wave of quantitative innovation in finance was led by Markowitz optimization. Machine Learning is the second wave and it will touch every aspect of finance. López de Prado's Advances in Financial Machine Learning is essential for readers who want to be ahead of the technology rather than being replaced by it."—Prof. Campbell Harvey, Duke University. Former President of the American Finance Association
"The complexity inherent to financial systems justifies the application of sophisticated mathematical techniques. Advances in Financial Machine Learning is an exciting book that unravels a complex subject in clear terms. I wholeheartedly recommend this book to anyone interested in the future of quantitative investments."—Prof. John C. Hull, University of Toronto, Author of Options, Futures, and other Derivatives
"Prado's book clearly illustrates how fast this world is moving, and how deep you need to dive if you are to excel and deliver top of the range solutions and above the curve performing algorithms... Prado's book is clearly at the bleeding edge of the machine learning world."—Irish Tech News
"Financial data is special for a key reason: The markets have only one past. There is no 'control group', and you have to wait for true out-of-sample data. Consequently, it is easy to fool yourself, and with the march of Moore's Law and the new machine learning, it's easier than ever. López de Prado explains how to avoid falling for these common mistakes. This is an excellent book for anyone working, or hoping to work, in computerized investment and trading."—Dr. David J. Leinweber, Former Managing Director, First Quadrant, Author of Nerds on Wall Street: Math, Machines and Wired Markets"In his new book, Dr. López de Prado demonstrates that financial machine learning is more than standard machine learning applied to financial datasets. It is an important field of research in its own right. It requires the development of new mathematical tools and approaches, needed to address the nuances of financial datasets. I strongly recommend this book to anyone who wishes to move beyond the standard Econometric toolkit."
—Dr. Richard R. Lindsey, Managing Partner, Windham Capital Management, Former Chief Economist, U.S. Securities and Exchange Commission"Dr. Lopez de Prado, a well-known scholar and an accomplished portfolio manager who has made several important contributions to the literature on machine learning (ML) in finance, has produced a comprehensive and innovative book on the subject. He has illuminated numerous pitfalls awaiting anyone who wishes to use ML in earnest, and he has provided much needed blueprints for doing it successfully. This timely book, offering a good balance of theoretical and applied findings, is a must for academics and practitioners alike."
—Prof. Alexander Lipton, Connection Science Fellow, Massachusetts Institute of Technology. Risk's Quant of the Year (2000)
"How does one make sense of todays’ financial markets in which complex algorithms route orders, financial data is voluminous, and trading speeds are measured in nanoseconds? In this important book, Marcos López de Prado sets out a new paradigm for investment management built on machine learning. Far from being a 'black box' technique, this book clearly explains the tools and process of financial machine learning. For academics and practitioners alike, this book fills an important gap in our understanding of investment management in the machine age."—Prof. Maureen O'Hara, Cornell University. Former President of the American Finance Association
"Marcos López de Prado has produced an extremely timely and important book on machine learning. The author's academic and professional first-rate credentials shine through the pages of this book - indeed, I could think of few, if any, authors better suited to explaining both the theoretical and the practical aspects of this new and (for most) unfamiliar subject. Both novices and experienced professionals will find insightful ideas, and will understand how the subject can be applied in novel and useful ways. The Python code will give the novice readers a running start, and will allow them to gain quickly a hands-on appreciation of the subject. Destined to become a classic in this rapidly burgeoning field."—Prof. Riccardo Rebonato, EDHEC Business School. Former Global Head of Rates and FX Analytics at PIMCO
"A tour de force on practical aspects of machine learning in finance brimming with ideas on how to employ cutting edge techniques, such as fractional differentiation and quantum computers, to gain insight and competitive advantage. A useful volume for finance and machine learning practitioners alike."—Dr. Collin P. Williams, Head of Research, D-Wave Systems