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 Machine Learning for
Algorithmic Trading

Second Edition
Predictive models to extract signals from market and
alternative data for systematic trading strategies with
Python

Stefan Jansen

BIRMINGHAM - MUMBAI
Machine Learning for Algorithmic
Trading

Second Edition

Copyright © 2020 Packt Publishing

All rights reserved. No part of this book may be reproduced, stored

in a retrieval system, or transmitted in any form or by any means,
without the prior written permission of the publisher, except in the
case of brief quotations embedded in critical articles or reviews.

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Producer: Tushar Gupta

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Project Editor: Carol Lewis

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First published: December 2018

Second edition: July 2020

Production reference: 1300720

Published by Packt Publishing Ltd.

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 Contributors

About the author

Stefan Jansen is the founder and CEO of Applied AI. He advises
Fortune 500 companies, investment firms, and start-ups across
industries on data and AI strategy, building data science teams, and
developing end-to-end machine learning solutions for a broad range
of business problems.

Before his current venture, he was a partner and managing director

at an international investment firm, where he built the predictive
analytics and investment research practice. He was also a senior
executive at a global fintech company with operations in 15 markets,
advised central banks in emerging markets, and consulted for the
World Bank.

He holds master's degrees in computer science from Georgia Tech

and in economics from Harvard and Free University Berlin, and a
CFA charter. He has worked in six languages across Europe, Asia,
and the Americas and taught data science at DataCamp and General
Assembly.

This thorough revision of the first edition was only possible with the
collaboration and support of my family, friends, and colleagues. I want to
thank the team at Packt for responding to reader feedback and taking the
project from start to finish. Chris Nelson was a thorough editor and
provided constructive advice. I want to thank my clients for the opportunity
to do such exciting work that often offered valuable inspiration for this book.

Most important, however, has been the unrelenting patience and support of
Mariana. To her and Bastian, who make it all worthwhile, I dedicate this
book.
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About the reviewers
Prem Jebaseelan has about 20 years of experience in handling
different financial data and enjoys the challenge of organizing,
storing, retrieving, and analyzing large volumes of data. Prem has
designed and implemented several enterprise-level solutions for
front office trading strategies, middle office, and back office
applications for funds, and has good experience in applying
machine learning and AI-based solutions. Prem has an engineering
degree.

Prem is currently the co-founder and CEO of Zentropy Technologies,

a fintech company that specializes in creating machine learning
based solutions in the financial domain. Prior to this, Prem worked
in one of the leading hedge funds as a technology solutions
provider.

I would like to thank all my previous employers who have helped me in

developing real-world solutions that bring technology and finance together.
I would specifically like to thank Dr Yves Hilpisch for our work together in
the application of machine learning to real-world trading strategies.
Ramanathan Ramakrishnamoorthy is one of the co founders and
directors at Zentropy Technologies. Ramanathan started his
professional career with a leading hedge fund and in his latest
position, he worked as a project manager responsible for building
tools and technologies required by the middle and back office. At
Zentropy, Ramanathan is primarily responsible for better
understanding project requirements and converting them to
technical specs. alongside executing them. Having a keen eye for
subtle data patterns, Ramanathan also has a good understanding of
the machine learning and data science domain, particularly with
expertise in the time series analysis domain. Ramanathan's
experience has primarily been around building trading systems,
quant warehouses, and backtesting engines for capital markets.

Ramanathan is also an active core group member in the Hyderabad

Python group. He leads some of the most important activities of the
community, like organizing conferences, monthly meetups, and
conducting Python sessions at colleges.
Contents
Preface
What to expect
What's new in the second edition
Who should read this book
What this book covers
To get the most out of this book
Get in touch
1. Machine Learning for Trading – From Idea to Execution
The rise of ML in the investment industry
From electronic to high-frequency trading
Factor investing and smart beta funds
Algorithmic pioneers outperform humans
ML-driven funds attract $1 trillion in AUM
The emergence of quantamental funds
Investments in strategic capabilities
ML and alternative data
Crowdsourcing trading algorithms
Designing and executing an ML-driven strategy
Sourcing and managing data
From alpha factor research to portfolio management
The research phase
The execution phase
Strategy backtesting
ML for trading – strategies and use cases
The evolution of algorithmic strategies
Use cases of ML for trading
Data mining for feature extraction and insights
Supervised learning for alpha factor creation
Asset allocation
Testing trade ideas
Reinforcement learning
Summary
2. Market and Fundamental Data – Sources and Techniques
Market data reflects its environment
Market microstructure – the nuts and bolts
How to trade – different types of orders
Where to trade – from exchanges to dark pools
Working with high-frequency data
How to work with Nasdaq order book data
Communicating trades with the FIX protocol
The Nasdaq TotalView-ITCH data feed
How to parse binary order messages
Summarizing the trading activity for all 8,500
stocks
How to reconstruct all trades and the order book
From ticks to bars – how to regularize market data
The raw material – tick bars
Plain-vanilla denoising – time bars
Accounting for order fragmentation – volume bars
Accounting for price changes – dollar bars
AlgoSeek minute bars – equity quote and trade data
From the consolidated feed to minute bars
Quote and trade data fields
How to process AlgoSeek intraday data
API access to market data
Remote data access using pandas
Reading HTML tables
pandas-datareader for market data
yfinance – scraping data from Yahoo! Finance
How to download end-of-day and intraday prices
How to download the option chain and prices
Quantopian
Zipline
Quandl
Other market data providers
How to work with fundamental data
Financial statement data
Automated processing – XBRL
 Building a fundamental data time series
Other fundamental data sources
pandas-datareader – macro and industry data
Efficient data storage with pandas
Summary
3. Alternative Data for Finance – Categories and Use Cases
The alternative data revolution
Sources of alternative data
Individuals
Business processes
Sensors
Satellites
Geolocation data
Criteria for evaluating alternative data
Quality of the signal content
Asset classes
Investment style
Risk premiums
Alpha content and quality
Quality of the data
Legal and reputational risks
Exclusivity
Time horizon
Frequency
Reliability
Technical aspects
Latency
Format
The market for alternative data
Data providers and use cases
Social sentiment data
Satellite data
Geolocation data
Email receipt data
Working with alternative data
Scraping OpenTable data
 Parsing data from HTML with Requests and
BeautifulSoup
Introducing Selenium – using browser automation
Building a dataset of restaurant bookings and
ratings
Taking automation one step further with Scrapy
and Splash
Scraping and parsing earnings call transcripts
Summary
4. Financial Feature Engineering – How to Research Alpha Factors
Alpha factors in practice – from data to signals
Building on decades of factor research
Momentum and sentiment – the trend is your friend
Why might momentum and sentiment drive excess
returns?
How to measure momentum and sentiment
Value factors – hunting fundamental bargains
Relative value strategies
Why do value factors help predict returns?
How to capture value effects
Volatility and size anomalies
Why do volatility and size predict returns?
How to measure volatility and size
Quality factors for quantitative investing
Why quality matters
How to measure asset quality
Engineering alpha factors that predict returns
How to engineer factors using pandas and NumPy
Loading, slicing, and reshaping the data
Resampling – from daily to monthly frequency
How to compute returns for multiple historical
periods
Using lagged returns and different holding periods
Computing factor betas
How to add momentum factors
Adding time indicators to capture seasonal effects
 How to create lagged return features
How to create forward returns
How to use TA-Lib to create technical alpha factors
Denoising alpha factors with the Kalman filter
How does the Kalman filter work?
How to apply a Kalman filter using pykalman
How to preprocess your noisy signals using wavelets
From signals to trades – Zipline for backtests
How to backtest a single-factor strategy
A single alpha factor from market data
Built-in Quantopian factors
Combining factors from diverse data sources
Separating signal from noise with Alphalens
Creating forward returns and factor quantiles
Predictive performance by factor quantiles
The information coefficient
Factor turnover
Alpha factor resources
Alternative algorithmic trading libraries
Summary
5. Portfolio Optimization and Performance Evaluation
How to measure portfolio performance
Capturing risk-return trade-offs in a single number
The Sharpe ratio
The information ratio
The fundamental law of active management
How to manage portfolio risk and return
The evolution of modern portfolio management
Mean-variance optimization
How it works
Finding the efficient frontier in Python
Challenges and shortcomings
Alternatives to mean-variance optimization
The 1/N portfolio
The minimum-variance portfolio
 Global Portfolio Optimization – the Black-Litterman
approach
How to size your bets – the Kelly criterion
Optimal investment – multiple assets
Risk parity
Risk factor investment
Hierarchical risk parity
Trading and managing portfolios with Zipline
Scheduling signal generation and trade execution
Implementing mean-variance portfolio optimization
Measuring backtest performance with pyfolio
Creating the returns and benchmark inputs
Getting pyfolio input from Alphalens
Getting pyfolio input from a Zipline backtest
Walk-forward testing – out-of-sample returns
Summary performance statistics
Drawdown periods and factor exposure
Modeling event risk
Summary
6. The Machine Learning Process
How machine learning from data works
The challenge – matching the algorithm to the task
Supervised learning – teaching by example
Unsupervised learning – uncovering useful patterns
Use cases – from risk management to text
processing
Cluster algorithms – seeking similar observations
Dimensionality reduction – compressing
information
Reinforcement learning – learning by trial and error
The machine learning workflow
Basic walkthrough – k-nearest neighbors
Framing the problem – from goals to metrics
Prediction versus inference
Regression – popular loss functions and error
metrics
 Classification – making sense of the confusion
matrix
Collecting and preparing the data
Exploring, extracting, and engineering features
Using information theory to evaluate features
Selecting an ML algorithm
Design and tune the model
The bias-variance trade-off
Underfitting versus overfitting – a visual example
How to manage the bias-variance trade-off
Learning curves
How to select a model using cross-validation
How to implement cross-validation in Python
KFold iterator
Leave-one-out CV
Leave-P-Out CV
ShuffleSplit
Challenges with cross-validation in finance
Time series cross-validation with scikit-learn
Purging, embargoing, and combinatorial CV
Parameter tuning with scikit-learn and Yellowbrick
Validation curves – plotting the impact of
hyperparameters
Learning curves – diagnosing the bias-variance
trade-off
Parameter tuning using GridSearchCV and pipeline
Summary
7. Linear Models – From Risk Factors to Return Forecasts
From inference to prediction
The baseline model – multiple linear regression
How to formulate the model
How to train the model
Ordinary least squares – how to fit a hyperplane to
the data
Maximum likelihood estimation
Gradient descent
 The Gauss–Markov theorem
How to conduct statistical inference
How to diagnose and remedy problems
Goodness of fit
Heteroskedasticity
Serial correlation
Multicollinearity
How to run linear regression in practice
OLS with statsmodels
Stochastic gradient descent with sklearn
How to build a linear factor model
From the CAPM to the Fama–French factor models
Obtaining the risk factors
Fama–Macbeth regression
Regularizing linear regression using shrinkage
How to hedge against overfitting
How ridge regression works
How lasso regression works
How to predict returns with linear regression
Preparing model features and forward returns
Creating the investment universe
Selecting and computing alpha factors using TA-
Lib
Adding lagged returns
Generating target forward returns
Dummy encoding of categorical variables
Linear OLS regression using statsmodels
Selecting the relevant universe
Estimating the vanilla OLS regression
Diagnostic statistics
Linear regression using scikit-learn
Selecting features and targets
Cross-validating the model
Evaluating the results – information coefficient and
RMSE
Ridge regression using scikit-learn
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 Tuning the regularization parameters using cross-
validation
Cross-validation results and ridge coefficient paths
Top 10 coefficients
Lasso regression using sklearn
Cross-validating the lasso model
Evaluating the results – IC and lasso path
Comparing the quality of the predictive signals
Linear classification
The logistic regression model
The objective function
The logistic function
Maximum likelihood estimation
How to conduct inference with statsmodels
Predicting price movements with logistic regression
How to convert a regression into a classification
problem
Cross-validating the logistic regression
hyperparameters
Evaluating the results using AUC and IC
Summary
8. The ML4T Workflow – From Model to Strategy Backtesting
How to backtest an ML-driven strategy
Backtesting pitfalls and how to avoid them
Getting the data right
Look-ahead bias – use only point-in-time data
Survivorship bias – track your historical universe
Outlier control – do not exclude realistic extremes
Sample period – try to represent relevant future
scenarios
Getting the simulation right
Mark-to-market performance – track risks over
time
Transaction costs – assume a realistic trading
environment
 Timing of decisions – properly sequence signals
and trades
Getting the statistics right
The minimum backtest length and the deflated SR
Optimal stopping for backtests
How a backtesting engine works
Vectorized versus event-driven backtesting
Key implementation aspects
Data ingestion – format, frequency, and timing
Factor engineering – built-in factors versus
libraries
ML models, predictions, and signals
Trading rules and execution
Performance evaluation
backtrader – a flexible tool for local backtests
Key concepts of backtrader's Cerebro architecture
Data feeds, lines, and indicators
From data and signals to trades – strategy
Commissions instead of commission schemes
Making it all happen – Cerebro
How to use backtrader in practice
How to load price and other data
How to formulate the trading logic
How to configure the Cerebro instance
backtrader summary and next steps
Zipline – scalable backtesting by Quantopian
Calendars and the Pipeline for robust simulations
Bundles – point-in-time data with on-the-fly
adjustments
The Algorithm API – backtests on a schedule
Known issues
Ingesting your own bundles with minute data
Getting your data ready to be bundled
Writing your custom bundle ingest function
Registering your bundle
Creating and registering a custom TradingCalendar
 The Pipeline API – backtesting an ML signal
Enabling the DataFrameLoader for our Pipeline
Creating a pipeline with a custom ML factor
How to train a model during the backtest
Preparing the features – how to define pipeline
factors
How to design a custom ML factor
Tracking model performance during a backtest
Instead of how to use
Summary
9. Time-Series Models for Volatility Forecasts and Statistical
Arbitrage
Tools for diagnostics and feature extraction
How to decompose time-series patterns
Rolling window statistics and moving averages
How to measure autocorrelation
How to diagnose and achieve stationarity
Transforming a time series to achieve stationarity
Handling instead of how to handle
On unit roots and random walks
How to diagnose a unit root
How to remove unit roots and work with the
resulting series
Time-series transformations in practice
Univariate time-series models
How to build autoregressive models
How to identify the number of lags
How to diagnose model fit
How to build moving-average models
How to identify the number of lags
The relationship between the AR and MA models
How to build ARIMA models and extensions
How to model differenced series
How to identify the number of AR and MA terms
Adding features – ARMAX
Adding seasonal differencing – SARIMAX
 How to forecast macro fundamentals
How to use time-series models to forecast volatility
The ARCH model
Generalizing ARCH – the GARCH model
How to build a model that forecasts volatility
Multivariate time-series models
Systems of equations
The vector autoregressive (VAR) model
Using the VAR model for macro forecasts
Cointegration – time series with a shared trend
The Engle-Granger two-step method
The Johansen likelihood-ratio test
Statistical arbitrage with cointegration
How to select and trade comoving asset pairs
Pairs trading in practice
Distance-based heuristics to find cointegrated
pairs
How well do the heuristics predict significant
cointegration?
Preparing the strategy backtest
Precomputing the cointegration tests
Getting entry and exit trades
Backtesting the strategy using backtrader
Tracking pairs with a custom DataClass
Running and evaluating the strategy
Extensions – how to do better
Summary
10. Bayesian ML – Dynamic Sharpe Ratios and Pairs Trading
How Bayesian machine learning works
How to update assumptions from empirical evidence
Exact inference – maximum a posteriori estimation
How to select priors
How to keep inference simple – conjugate priors
Dynamic probability estimates of asset price
moves
Deterministic and stochastic approximate inference
 Markov chain MonteCarlo sampling
Variational inference and automatic differentiation
Probabilistic programming with PyMC3
Bayesian machine learning with Theano
The PyMC3 workflow – predicting a recession
The data – leading recession indicators
Model definition – Bayesian logistic regression
Exact MAP inference
Approximate inference – MCMC
Approximate inference – variational Bayes
Model diagnostics
How to generate predictions
Summary and key takeaways
Bayesian ML for trading
Bayesian Sharpe ratio for performance comparison
Defining a custom probability model
Comparing the performance of two return series
Bayesian rolling regression for pairs trading
Stochastic volatility models
Summary
11. Random Forests – A Long-Short Strategy for Japanese Stocks
Decision trees – learning rules from data
How trees learn and apply decision rules
Decision trees in practice
The data – monthly stock returns and features
Building a regression tree with time-series data
Building a classification tree
Visualizing a decision tree
Evaluating decision tree predictions
Overfitting and regularization
How to regularize a decision tree
Decision tree pruning
Hyperparameter tuning
Using GridsearchCV with a custom metric
How to inspect the tree structure
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 *** END OF THE PROJECT GUTENBERG EBOOK HEMMING, THE
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