I always thought that inspiration and experience is a key factor in trading. But everytime my chess computer beats me without any inspiration, just by brute force, I start to reconsider this assumption. This article will be about a brute force approach in trading.
Rule based trading
I have never been a great believer in classical technical analysis. If you ask 2 analysts about the current trend in the market, you get at least 3 answers. So I turned to algorithmic trading, using the tools of technical analysis in a new way, doing if..then conditions, backtesting them, refining the rules and parameters until the desired result was shown. These if..then based conditions, like if the market is above it`s 200 day line then go long, are mostly found by experience and inspiration. Isn’t my brain just a neural network which can be trained with historic data (experience), enhanced with a glass of wine for the inspiration?
Today I would like to take a voyage into machine learning. I would like to let my computer find the rules by itself, and just decide if I like the results or not. I’ll have the glass of wine with some friends and let the machine do the job; This sounds tempting to me, but can life really be as easy?
Unsupervised machine learning – kNN algorithm
The knn algorithm is one of the most simple machine learning algorithms. Learning might be the wrong label, in reality it is more of a classification algorithm. But first let’s see how it works.
The scatter chart above is a visualization of a two dimensional kNN data set. For this article I used a long term and a short term RSI. The dots represent the historic RSI values. Have a look at the fat circled point. It just means, that todays RSI1 has a value of 63, and RSI2 got a value of 70. Additionally the dots have got colours. A green dot means the market moved up on the following day, a red dot shows a falling market on the day after.
kNN – k nearest neighbours
To do a prediction of tomorrow’s market move, the kNN algorithm has a look at the historic data (shown on the scatter plot) and finds the k nearest neighbours of today’s RSI values. As you can see, our current fat point is surrounded by red dots. This means, that every time the 2 RSI values have been in this area, the market fell on the day after. That’s why today’s data point is classified as red. Call it classification or prediction, the kNN algorithm just has a look on what has happened in the past when the RSI indicators had a similar level. Have a look at this video, it is a great explanation on how the algorithm works.
kNN in Tradesignal
Computer kiddies would implement this algorithm in Python or R, but I would like to show you an implementation with the Tradesignal programming language Equilla. It is way faster than Python, and has got the advantage that I can directly see all the advantages and disadvantages on the chart. It is not just number crunching.
To implement the algorithm in Tradesignal we first have to do the shown scatter plot, but not graphically but store the 2 rsi values and the next days market move(colour of dots) into an array.
In line 8&9 the rsi values are calculated, line 12&13 calculates the next day`s market move. Line 15 to 20 then stores the data into the training data array. This is done for the first half of the data set, for my example I will use the data from bar 50 to 1000 on my chart of 2000 data points.
The next task to complete is to calculate the distances of today’s rsi point to all the historic points in the training data set.
Line 23 to 27 calculates the euclidean distance of today’s point to all historic points, line 29 then creates a sorted list of all these distances to find the k nearest historic data points in the training data set.
We are nearly done. The next step is just to find out what classification (colour) the nearest points have got and use this information to create a prediction for tomorrow. This is done in lines 33 to 35
Have a look at the scatter chart at the beginning. If this would be the data stored in our training data set, the prediction, using the 5 nearest neighbours, would be -5. All the 5 nearest neighbours of our current data point are red.
Now that we got a prediction for tomorrow, we just have to trade it:
kNN algorithm performance
Lets have a look if this simple machine learning algorithm works. Using 2000 days of backward adjusted brent data, I used a 14 and 28 day RSI to predict the next day move. The training was done on bar 50 to 1000, and I used the 5 nearest neighbours for the classification.
Knn algorithm – conclusion
Judging on the shown graph it seems to work. It seems to be possible to use these 2 RSI indicators to predict tomorrow’s brent move.
kNN algorithm gives me a framework to test all kind of indicators or even different data sets easily and see if they have got any predictive value.
This is definitely an addition to classical algorithmic trading, using if..then conditions build from experience and intuition.
But you might still need some intuition to find the right data sets, indicators and parameters to get a useful prediction. Not everything can be done by machine learning…