Learn how the factor of time affects trading and investing

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Impact Of Artificial Intelligence And Machine Learning on Trading And Investing

Below are excerpts from a presentation I gave a few months ago in Europe as an invited speaker to a group of low profile but high net worth investors and traders. The subject was determined by the organizer to be about the impact of artificial intelligence and machine learning on trading and investing. The excerpts below are organized in four sections and cover about 50% of the original presentation.

1. General impact of artificial intelligence and machine learning on trading

Artificial Intelligence (AI) allows replacing humans with machines. In the 1980s, AI research focused primarily on expert systems and fuzzy logic. With computational power becoming cheaper, using machines to solve large-scale optimization problems became economically feasible. As a result of the advances in hardware and software, nowadays AI focuses on the use of neural networks and other learning methods for identifying and analyzing predictors, also known as features, or factors, that have economic value and can be used with classifiers to develop profitable models. This particular application of AI often goes by the name Machine Learning (ML).

The application of methods for developing trading strategies based on AI, both in short-term time frames and for longer-term investing, is gaining popularity and there are a few hedge funds that are very active in this field. However, broad acceptance of this new technology is slow due to various factors, the most important being that AI requires investment in new tools and human talent. The majority of funds use fundamental analysis because this is what managers learn in their MBA programs. There are not many hedge funds that rely solely on AI. Application of AI is growing at the retail level but the majority of traders still use methods that were proposed in mid twentieth century, including traditional technical analysis, because they are easy to learn and apply.

Note that AI and ML are not only used to develop trading strategies but also in other areas, for example in developing liquidity searching algos and suggesting portfolios to clients. Therefore, with AI applications gaining ground, the number of humans involved in trading and investment decisions decreases and this obviously affects markets and price action. It is early to speculate on the overall effects this new technology will have on the industry but it is possible that extensive use of AI will result in more efficient markets with lower volatility for extended periods of time followed by occasional volatility spikes due to regime changes. This is possible because the impact of subjective evaluation of information by humans will be minimized and with that the associated noise. But that remains to be seen in practice.

2. Impact of artificial intelligence and machine learning on alpha generation

During these initial phases of the adoption of AI technology there will be opportunities for those who understand it and know how to manage its risks. One problem with trading strategies based on AI is that they can yield models that are worse than random. I will try to explain what I mean by this: traditional technical analysis is an unprofitable method of trading because strategies based on chart patterns and indicators draw their returns from a distribution with zero mean before any transaction costs. Some traders will always be found at the right tail of the distribution and this gives the false impression that these methods have economic value. My research shows that especially in the futures and forex markets, longer-term profitability is hard to achieve no matter which method is used because these markets are designed to benefit market makers. However, in shorter periods of time some traders can realize large profits in leveraged markets due to luck. Then, these traders attribute their success to their strategies and skills, rather than to luck.

With AI and ML, there are additional effects, such as the bias-variance trade-off. Data-mining bias can result in strategies that are over-fitted to past data but immediately fail on new data, or strategies that are too simple and do not capture important signals in the data that have economic value. The result of this trade-off is worse-than-random strategies and a negative skew in the distribution of returns of these traders even before transaction cost is added. This presents an opportunity for profit for large funds and investors in the post-quantitative easing era. However, as the worse-than-random AI traders are being removed from the market and only those with robust models remain, the battle for profits will become intense. It is too early to speculate whether AI traders or large investors will win this battle.

I would also like to mention a common misconception in this area: some people believe that the value is in the ML algos used. This is not true. The true value is in the predictors used, also known as features or factors. ML algorithms cannot find gold where there is none. One problem is that most ML professionals use the same predictors and try to develop models in an iterative fashion that will produce the best results. This process is plagued by data-mining bias and eventually fails. In a nutshell, data-mining bias results from the dangerous practice of using data multiple times with many models until results are acceptable in the training and testing samples. My research in this area indicates that if a simple classifier, such as Binary Logistic Regression, does not work satisfactorily with a given set of predictors, then it is highly likely that there is no economic value. Therefore, success depends on what is called feature engineering, and this is both a science and an art that requires knowledge, experience and imagination to come up with features that have economic value and only a small percentage of professionals can do that.

3. Impact of artificial intelligence and machine learning on technical analysis

We have to make a distinction between traditional and quantitative technical analysis because all methods that rely on the analysis of price and volume series fall under this subject. Traditional technical analysis, i.e., chart patterns, some simple indicators, certain theories of price action, etc., was not effective to start with. Other than a few incomplete efforts of limited scope and reach, publications that touted these methods never presented their longer-term statistical expectation but offered only promises that if this or that rule is used there would be profit potential. Since profits and losses in the markets follow some statistical distribution, there were always those who attributed their luck to these methods. At the same time, a whole industry developed around these methods because there were easy to learn. Unfortunately, many thought they could profit by being better at using methods known to everyone else and the result was massive wealth transfer from these naïve traders to market makers and other well-informed professionals.

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In the early 1990s, some market professionals realized that a large number of retail traders were trading using these naive methods. Some developed algos and AI expert systems to identify the formations in advance and then trade against them, causing in the process volatility that retail traders, also known as weak hands, could not cope with. In a more fundamental way, the failure of traditional technical analysis can be attributed to the disappearance of high serial correlation from the markets starting in the 1990s. It was basically the high serial correlation that offered the wrong impression that these methods worked. Nowadays, with few exceptions, markets are mean-reverting, not leaving room to simple technical analysis methods to work. However, some quantitative technical analysis methods often work well, such as mean-reversion and statistical arbitrage models, including ML algorithms that use features with economic value.

Note that this type of arbitrage is unlikely to be repeated in the case of AI and ML because of the great variety of models and the fact that most are being kept proprietary but the main problem with this new technology is not confirmation bias, as in the case of traditional technical analysis, but data-mining bias.

In my opinion, observing the market and looking at charts is becoming an obsolete process. The future of trading is about processing information, developing and validating models in real-time. The hedge fund of the future will not rely on chart analysis. Some still do this because they are at the transition boundary where old ways meet with a new era. Many traders not familiar with AI will find it hard to compete in the future and will withdraw.

4. Winners and losers of the new trading technology

Application of AI will change trading in many ways and this is already happening. Investors may find out soon that medium-term returns will be much below expectations after the current trend caused by QE expires. If this scenario materializes, then investors will have to return to the old way of finding a good financial adviser that can suggest a portfolio mix and pick securities that will appreciate in value. In some cases, the adviser will be an AI program and this process will be executed online.

Traders need to get familiar with this new technology. Most traders are still struggling with old methods and just hope that “buy the dip” will work and provide profits for a few more years.

One of the problems is the moral hazard cultivated by the central bank with direct support of the financial markets in the last eight years. Many traders and investors now believe that bear markets are not possible because the central bank will be there to redistribute their losses to everyone else although they can keep their profits. As a result, most market participants are unprepared for the next major market regime change and may face devastating losses.

There are excellent resources in the web about ML, AI and trading. The best way of learning is by trying to solve a few practical problems. But I believe the transition for most traders will not be possible. The combination of skills required for understanding and applying AI rules out 95% of traders used to drawing lines on charts and watching moving averages.

Investors should do their own research and consult a competent financial adviser who is familiar with these new developments. Every investor has different risk aversion profile and it is difficult to offer general guidelines. There will be a proliferation of robo-advisors soon and selecting one that suits particular needs and objectives may turn out to be a challenging task.

Anyone not familiar with ML and AI and their relation to trading and investing may find it more profitable to consult a professional who is up to speed in this area rather than embarking in a journey of reading books and articles, which is something that can be done after the basics are understood. I hope I have provided a general idea in this presentation that can serve as a starting point in this interesting and potentially rewarding endeavor.

If you have any questions or comments, happy to connect on Twitter:@mikeharrisNY

About the author: Michael Harris is a trader and best selling author. He is also the developer of the first commercial software for identifying parameter-less patterns in price action 17 years ago. In the last seven years he has worked on the development of DLPAL, a software program that can be used to identify short-term anomalies in market data for use with fixed and machine learning models. Click here for more.

How to Use Volume to Improve Your Trading

Volume is a measure of how much of a given financial asset has traded in a period of time. For stocks, volume is measured in the number of shares traded and, for futures and options, it is based on how many contracts have changed hands. The numbers, and other indicators that use volume data, are often provided with online charts. Looking at volume patterns over time can help get a sense of the strength or conviction behind advances and declines in specific stocks and entire markets.

Basic Guidelines for Using Volume

When analyzing volume, there are usually guidelines used to determine the strength or weakness of a move. As traders, we are more inclined to join strong moves and take no part in moves that show weakness—or we may even watch for an entry in the opposite direction of a weak move. These guidelines do not hold true in all situations, but they offer general guidance for trading decisions.

Key Takeaways

  • Volume measures the number of shares traded in a stock or contracts traded in futures or options.
  • Volume can be an indicator of market strength, as rising markets on increasing volume are typically viewed as strong and healthy.
  • When prices fall on increasing volume, the trend is gathering strength to the downside.
  • When prices reach new highs (or no lows) on decreasing volume, watch out; a reversal might be taking shape.
  • On Balance Volume and Klinger Indicator are examples of charting tools that are based on volume.

Trend Confirmation

A rising market should see rising volume. Buyers require increasing numbers and increasing enthusiasm in order to keep pushing prices higher. Increasing price and decreasing volume might suggest a lack of interest, and this is a warning of a potential reversal. This can be hard to wrap your mind around, but the simple fact is that a price drop (or rise) on little volume is not a strong signal. A price drop (or rise) on large volume is a stronger signal that something in the stock has fundamentally changed.

Exhaustion Moves and Volume

In a rising or falling market, we can see exhaustion moves. These are generally sharp moves in price combined with a sharp increase in volume, which signals the potential end of a trend. Participants who waited and are afraid of missing more of the move pile in at market tops, exhausting the number of buyers.

At a market bottom, falling prices eventually force out large numbers of traders, resulting in volatility and increased volume. We will see a decrease in volume after the spike in these situations, but how volume continues to play out over the next days, weeks, and months can be analyzed using the other volume guidelines.

Bullish Signs

Volume can be useful in identifying bullish signs. For example, imagine volume increases on a price decline and then the price moves higher, followed by a move back lower. If the price on the move back lower doesn’t fall below the previous low, and volume is diminished on the second decline, then this is usually interpreted as a bullish sign.

Volume and Price Reversals

After a long price move higher or lower, if the price begins to range with little price movement and heavy volume, this might indicate that a reversal is underway, and prices will change direction.

Volume and Breakouts vs. False Breakouts

On the initial breakout from a range or other chart pattern, a rise in volume indicates strength in the move. Little change in volume or declining volume on a breakout indicates a lack of interest and a higher probability for a false breakout.

Volume is often viewed as an indicator of liquidity, as stocks or markets with the most volume are the most liquid and considered the best for short-term trading; there are many buyers and sellers ready to trade at various prices.

Volume History

Volume should be looked at relative to recent history. Comparing today to volume 50 years ago might provide irrelevant data. The more recent the data sets, the more relevant they are likely to be.

Volume Indicators

Volume indicators are mathematical formulas that are visually represented in most commonly used charting platforms. Each indicator uses a slightly different formula, and traders should find the indicator that works best for their particular market approach. Indicators are not required, but they can aid in the trading decision process. There are many volume indicators to choose from, and the following provides a sampling of how several of them can be used.

On Balance Volume (OBV): OBV is a simple but effective indicator. Volume is added (starting with an arbitrary number) when the market finishes higher, or volume is subtracted when the market finishes lower. This provides a running total and shows which stocks are being accumulated. It can also show divergences, such as when a price rises, but volume is increasing at a slower rate or even beginning to fall.

Chaikin Money Flow: Rising prices should be accompanied by rising volume, so Chaikin Money Flow focuses on expanding volume when prices finish in the upper or lower portion of their daily range and then provides a value for the corresponding strength. When closing prices are in the upper portion of the day’s range, and volume is expanding, the values will be high; when closing prices are in the lower portion of the range, values will be negative. Chaikin money flow can be used as a short-term indicator because it oscillates, but it is more commonly used for seeing divergence.

Klinger Oscillator: Fluctuation above and below the zero line can be used to aid other trading signals. The Klinger oscillator sums the accumulation (buying) and distribution (selling) volumes for a given time period.

Stock Market Basics: What Beginner Investors Should Know

If you’re not well-versed in the basics of the stock market, the stock trading information spewing from CNBC or the markets section of your favorite newspaper can border on gibberish.

Phrases like “earnings movers” and “intraday highs” don’t mean much to the average investor, and in many cases, they shouldn’t. If you’re in it for the long term — with, say, a portfolio of mutual funds geared toward retirement — you don’t need to worry about what these words mean, or about the flashes of red or green that cross the bottom of your TV screen. You can get by just fine without understanding the stock market much at all.

If, on the other hand, you want to learn how to trade stocks, you do need to understand the stock market, and at least some basic information about how stock trading works.

Stock market basics

The stock market is made up of exchanges, like the New York Stock Exchange and the Nasdaq. Stocks are listed on a specific exchange, which brings buyers and sellers together and acts as a market for the shares of those stocks. The exchange tracks the supply and demand — and directly related, the price — of each stock. (Need to back up a bit? Read our explainer about stocks.)

You place your stock trades through the broker, which then deals with the exchange on your behalf.

But this isn’t your typical market, and you can’t show up and pick your shares off a shelf the way you select produce at the grocery store. Individual traders are typically represented by brokers — these days, that’s often an online broker. You place your stock trades through the broker, which then deals with the exchange on your behalf. (Need a broker? See our analysis of the best stockbrokers for beginners.)

The NYSE and the Nasdaq are open from 9:30 a.m. to 4 p.m. Eastern, with premarket and after-hours trading sessions also available, depending on your broker.

Understanding the stock market

When people refer to the stock market being up or down, they’re generally referring to one of the major market indexes.

A market index tracks the performance of a group of stocks, which either represents the market as a whole or a specific sector of the market, like technology or retail companies. You’re likely to hear most about the S&P 500, the Nasdaq composite and the Dow Jones Industrial Average; they are often used as proxies for the performance of the overall market.

Investors use indexes to benchmark the performance of their own portfolios and, in some cases, to inform their stock trading decisions. You can also invest in an entire index through index funds and exchange-traded funds, or ETFs, which track a specific index or sector of the market. Read more about ETFs here.

Stock trading information

Most investors would be well-advised to build a diversified portfolio of stocks or stock index funds and hold on to it through good times and bad. But investors who like a little more action engage in stock trading. Stock trading involves buying and selling stocks frequently in an attempt to time the market.

The goal of stock traders is to capitalize on short-term market events to sell stocks for a profit, or buy stocks at a low. Some stock traders are day traders, which means they buy and sell several times throughout the day. Others are simply active traders, placing a dozen or more trades per month.

Investors who trade stocks do extensive research, often devoting hours a day to following the market. They rely on technical analysis, using tools to chart a stock’s movements in an attempt to find trading opportunities and trends. Many online brokers offer stock trading information, including analyst reports, stock research and charting tools.

Bull markets vs. bear markets

Neither is an animal you’d want to run into on a hike, but the market has picked the bear as the true symbol of fear: A bear market means stock prices are falling — thresholds vary, but generally to the tune of 20% or more — across several of the indexes referenced earlier.

Younger investors may be familiar with the term bear market but unfamiliar with the experience: We’ve been in a bull market — with rising prices, the opposite of a bear market — since March 2009 . That makes it the longest bull run in history.

It came out of the Great Recession, however, and that’s how bulls and bears tend to go: Bull markets are followed by bear markets, and vice versa, with both often signaling the start of larger economic patterns. In other words, a bull market typically means investors are confident, which indicates economic growth. A bear market shows investors are pulling back, indicating the economy may do so as well.

Bull markets are followed by bear markets, and vice versa, with both often signaling the start of larger economic patterns.

The good news is that the average bull market far outlasts the average bear market, which is why over the long term you can grow your money by investing in stocks.

The S&P 500, which holds around 500 of the largest stocks in the U.S., has historically returned an average of around 7% annually, when you factor in reinvested dividends and adjust for inflation. That means if you invested $1,000 30 years ago, you could have around $7,600 today.

Stock market crash vs. correction

A stock market correction happens when the stock market drops by 10% or more. A stock market crash is a sudden, very sharp drop in stock prices, like in October 1987 when stocks plunged 23% in a single day.

While crashes can herald a bear market, remember what we mentioned above: Most bull markets last longer than bear markets — which means stock markets tend to rise in value over time.

Worried about a crash? Focus on the long term

When the stock market declines, it can be difficult to watch your portfolio’s value shrink in real time and do nothing about it. However, if you’re investing for the long term, doing nothing is often the best course.

Thirty-two percent of Americans who were invested in the stock market during at least one of the last five financial downturns pulled some or all of their money out of the market. That’s according to a NerdWallet-commissioned survey, which was conducted online by The Harris Poll of more than 2,000 U.S. adults, among whom over 700 were invested in the stock market during at least one of the past five financial downturns, in June 2020. The survey also found that 28% of Americans would not keep their money in the stock market if there were a crash today.

It’s likely some of these Americans might rethink pulling their money if they knew how quickly a portfolio can rebound from the bottom: The market took just 13 months to recover its losses after the most recent major sell-off in 2020. Even the Great Recession — a devastating downturn of historic proportions — posted a complete market recovery in just over five years. The S&P 500 then posted a compound annual growth rate of 16% from 2020 to 2020 (including dividends).

If you’re wondering why you should wait years for your portfolio to get back to zero, remember what happens when you sell investments in a downturn: You lock in your losses. If you plan to re-enter the market at a sunnier time, you’ll almost certainly pay more for the privilege and sacrifice part (if not all) of the gains from the rebound.

Curious how long it would have taken to recover your losses after some of the stock market’s major downturns? Use our calculator to find out.

The importance of diversification

You can’t avoid bear markets as an investor. What you can avoid is the risk that comes from an undiversified portfolio.

Diversification helps protect your portfolio from inevitable market setbacks. If you throw all of your money into one company, you’re banking on success that can quickly be halted by regulatory issues, poor leadership or an E. coli outbreak.

To smooth out that company-specific risk, investors diversify by pooling multiple types of stocks together, balancing out the inevitable losers and eliminating the risk that one company’s contaminated beef will wipe out your entire portfolio.

But building a diversified portfolio of individual stocks takes a lot of time, patience and research. The alternative is a mutual fund, the aforementioned ETF or an index fund. These hold a basket of investments, so you’re automatically diversified. An S&P 500 ETF, for example, would aim to mirror the performance of the S&P 500 by investing in the 500 companies in that index.

The good news is you can combine individual stocks and funds in a single portfolio. One suggestion: Dedicate 10% or less of your portfolio to selecting a few stocks you believe in, and put the rest into index funds.

Ready to get started? The brokers below offer access to both individual stocks and funds.

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