# Introduction to Algorithmic Trading Strategies Lecture 2

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1 Introduction to Algorithmic Trading Strategies Lecture 2 Hidden Markov Trading Model Haksun Li

2 Outline Carry trade Momentum Valuation CAPM Markov chain Hidden Markov model 2

3 References Algorithmic Trading: Hidden Markov Models on Foreign Exchange Data. Patrik Idvall, Conny Jonsson. University essay from Linköpings universitet/matematiska institutionen; Linköpings universitet/matematiska institutionen A tutorial on hidden Markov models and selected applications in speech recognition. Rabiner, L.R. Proceedings of the IEEE, vol 77 Issue 2, Feb

4 FX Market FX is the largest and most liquid of all financial markets multiple trillions a day. FX is an OTC market, no central exchanges. The major players are: Central banks Investment and commercial banks Non bank financial institutions Commercial companies Retails 4

5 Electronic Markets Reuters EBS (Electronic Broking Service) Currenex FXCM FXall Hotspot Lava FX 5

6 Fees Brokerage Transaction, e.g., bid ask 6

7 Basic Strategies Carry trade Momentum Valuation 7

8 Carry Trade Capture the difference between the rates of two currencies. Borrow a currency with low interest rate. Buy another currency with higher interest rate. Take leverage, e.g., 10:1. Risk: FX exchange rate goes against the trade. Popular trades: JPY vs. USD, USD vs. AUD Worked until

9 Momentum FX tends to trend. Long when it goes up. Short when it goes down. Irrational traders Slow digestion of information among disparate participants 9

10 Purchasing Power Parity McDonald s hamburger as a currency. The price of a burger in the USA = the price of a burger in Europe E.g., USD1.25/burger = EUR1/burger EURUSD =

11 FX Index Deutsche Bank Currency Return (DBCR) Index A combination of Carry trade Momentum Valuation 11

12 CAPM Individual expected excess return is proportional to the market expected excess return., are geometric returns is an arithmetic return Sensitivity, 12

13 Alpha Alpha is the excess return above the expected excess return. For FX, we usually assume. 13

14 Bayes Theorem Bayes theorem computes the posterior probability of a hypothesis H after evidence E is observed in terms of the prior probability, the prior probability of E, the conditional probability of 14

15 Markov Chain a22 = 0.2 a12 = 0.2 s2: MEAN REVERTIN G a23 = 0.5 a21 = 0.3 a32 = 0.25 a13 = 0.4 s1: UP s3: DOWN a31 = 0.25 a11 = 0.4 a33 =

16 Example: State Probability What is the probability of observing Ω,,,

17 Markov Property Given the current information available at time, the history, e.g., path, is irrelevant. Consistent with the weak form of the efficient market hypothesis. 17

18 Hidden Markov Chain Only observations are observable (duh). World states may not be known (hidden). We want to model the hidden states as a Markov Chain. Two assumptions: Markov property,,,,, 18

19 Markov Chain a22 =? a12 =? s2: MEAN REVERTIN G a23 =? a21 =? a32 =? a13 =? s1: UP s3: DOWN a31 =? a11 =? a33 =? 19

20 Problems Likelihood Given the parameters, λ, and an observation sequence, Ω, compute Ω. Decoding Given the parameters, λ, and an observation sequence, Ω, determine the best hidden sequence Q. Learning Given an observation sequence, Ω, and HMM structure, learn λ. 20

21 Likelihood Solutions 21

22 Likelihood By Enumeration But this is not computationally feasible. 22

23 Forward Procedure the probability of the partial observation sequence until time t and the system in state at time t. Initialization : the conditional distribution of Induction Termination Ω, the likelihood 23

24 Backward Procedure the probability of the system in state at time t, and the partial observations from then onward till time t Initialization 1 Induction 24

25 Decoding Solutions 25

26 Decoding Solutions Given the observations and model, the probability of the system in state is:, 26

27 Maximizing The Expected Number Of States This determines the most likely state at every instant, t, without regard to the probability of occurrence of sequences of states. 27

28 Viterbi Algorithm The maximal probability of the system travelling these states and generating these observations: 28

29 Viterbi Algorithm Initialization Recursion max the probability of the most probable state sequence for the first t observations, ending in state j = argmax the state chosen at t Termination max = argmax 29

30 Learning Solutions 30

31 As A Maximization Problem Our objective is to find λ that maximizes. For any given λ, we can compute. Then solve a maximization problem. Algorithm: Nelder Mead. 31

32 Baum Welch the probability of being in state at time, and state at time, given the model and the observation sequence 32

33 Xi,, 33

34 Estimation Equation By summing up over time, ~ the number of times is visited ~ the number of times the system goes from state to state Thus, the parameters λ are:, initial state probabilities,,, transition probabilities, conditional probabilities 34

35 Estimation Procedure Guess what λ is. Compute λ using the estimation equations. Practically, we can estimate the initial λ by Nelder Mead to get closer to the solution. 35

36 Conditional Probabilities Our formulation so far assumes discrete conditional probabilities. The formulations that take other probability density functions are similar. But the computations are more complicated, and the solutions may not even be analytical, e.g., t distribution. 36

37 Heavy Tail Distributions t distribution Gaussian Mixture Model a weighted sum of Normal distributions 37

38 Trading Ideas Compute the next state. Compute the expected return. Long (short) when expected return > (<) 0. Long (short) when expected return > (<) c. c = the transaction costs Any other ideas? 38

39 Experiment Setup EURUSD daily prices from 2003 to unknown factors. Λ is estimated on a rolling basis. Evaluations: Hypothesis testing Sharpe ratio VaR Max drawdown alpha 39

40 Best Discrete Case 40

41 Best Continuous Case 41

42 Results More data (the 6 factors) do not always help (esp. for the discrete case). Parameters unstable. 42

43 TODOs How can we improve the HMM model(s)? Ideas? 43

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