How AI helps in predicting the stock market or business in 2020?

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Whether AI or Artificial intelligence systems can predict the stock market?  In this post, we will talk about whether financial crises can be modelled mathematically and predicted before the markets crash.  

Unlike my earlier post, this time the answer is yes, at least partially. The method is based on the assumption that the market has log-periodic oscillations and that super-exponential growth is not sustainable.  And I’ll explain what that means.  

How AI helps in predicting the stock market or business in 2020?



HOW TO INVEST IN STOCK MARKET USING AI?


Let's say you invested in some security that yielded 8% returns in the first year, 16%  in the second, 32% in the third, and 64% in the fourth year. 


Can we expect 128% returns next year?  

Sounds too good to be true, right?  

Because it most likely is.  Chances are it is either a Pyramid Scheme that is bound to collapse or a bubble that will burst at some point.  Riding bubbles can be profitable if we manage to get out on time.  


But can we predict when a bubble is most likely to burst?  

Can we at least guess whether it is very soon or not?   

By fitting a log-periodic-power function to historical prices, one can predict the most probable time of a crash.  Let’s take a look at their equation.  It may look a bit math-scary but bear with me. This function has 7 parameters.  

Let’s start with the one that we care about the most: the critical time, t_c.  This indicates when the market is likely to crash or change behaviour.  On the left-hand side of the equation, we have p(t), which is the price at a given time.  This function gives us the expected value of the logarithm of the price.  

The parameter A is a bias term that we can omit if the prices are normalized, otherwise,  it indicates the price at the peak of the bubble.  B indicates the height of the bubble, from top to bottom.  C is the relative magnitude of the fluctuations.  M is the exponent of the power-law growth.  Omega is the frequency of the log-periodic oscillations.  And phi is a phase-shift parameter.  


PARAMETERS WHICH HELPS IN DETERMINING THE MARKET:


The log-periodic power-law function is highly non-linear.  It has many local minima, has a high variance, and is hard to optimize.  Although it's a differentiable function, it's very fragile and is not very backpropagation friendly.  This paper proposes a relatively robust calibration scheme by reducing the number of non-linear parameters to three by rewriting the equation as this equation.  

Here, the only non-linear parameters are m, omega, and critical time, which can be solved  for by using local search methods such as the Nelder-Mead simplex method.  Even after this reformulation, this function is still highly sensitive to input.  For example, if we fit this function to the prices from the last 256 days rather than  512 days, we can get vastly different estimates of the critical time.  Ideally, we would want our bubble indicator to be consistent over different time scales so that we can have some confidence in our predictions.

We can do so by fitting LPPL curves over a range of window sizes and see how many of them warn us about an upcoming market crash.  That's what the LPPL Singularity Confidence Indicator aims to do. It gives the fraction of fits that satisfy a set of filtering conditions.  If a fit has parameters that fall between those ranges, it's considered a valid fit for a bubble. Those values were derived from historical data.  

To account for negative bubbles, bubbles that have a negative size are counted as -1.  Therefore the confidence score takes values between -1 and 1, where -1 means all of the fits were negative bubbles and 1 means all of the fits were positive bubbles. 

WHAT ARE LPPL BASED INDICATOR?


The higher the value, the likelier a crash is about to occur. The authors who proposed this method use window sizes that are evenly spaced between 125 and  750 trading days, where the size difference between consecutive windows is 5 days.  As you may guess, computing that many fits for every single time step are very computationally expensive.  They also have a short time scale version that spans windows between 20 days to 125  days, but I find it highly unstable, yet it still requires computing a lot of fits.  

So this is definitely not a suitable indicator for frequent trading which has created a website called the Financial Crisis Observatory.  They calculate this indicator for a variety of financial instruments and publish them on this website every day.  Their indicator was able to detect several crashes although it had some false positives as well.  


Can we use this to devise a trading strategy that consistently beats the market?  

We can try.  Let's see what happens if we simply set a threshold for the LPPL confidence indicator.  Sell if the risk of a bubble goes above it and buy again if it falls below.  As you can see, except for not suffering from one of the largest drawdowns, it doesn't really seem to do any better than the buy-and-hold strategy. 

 In this example, I simply used a threshold of 0.4.  We can tune our trading strategy further but tuning it too much can lead to implicit overfitting.  This thesis, for example, proposes and backtests more sophisticated trading strategies named,  the Dragon Hunting and Bubble Overlay strategies.  Both strategies rely on LPPL-based indicators.  My personal opinion is that none of these strategies is foolproof.  

LPPL-based indicators can be good for risk management but I don't think they can beat the market in terms of year over year gains.  LPPL aims to model the herd behaviour in financial markets but prices are driven by so many factors.  Hard behaviour, where people make decisions based on what everybody else is doing, is only one of them.  

When there is uncertainty in the market people tend to follow the crowd.  This behaviour is more prevalent in the cryptocurrency markets.  That's probably why some of the earlier Bitcoin bubbles are modelled almost perfectly with an LPPL function.  But obviously, this doesn't guarantee accurately predicting the next Bitcoin crash.  Markets may not be 100% efficient but it's very hard to find consistent inefficiencies in the market, especially if the number of participants in the market is sufficiently large.  So, I would personally keep an eye on these indicators, but wouldn't rely on them too much.

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