The Power of AI in Finance and Algorithmic Trading

Written by:

Mohamed Hafiz


November 13, 2023

Table of Content

Because AI, machine learning, and data science are radically transforming the world, we need to look into how they’re affecting finance and algorithmic trading, especially now when markets are so fragile and volatile.

Dr. Hugo Bowne-Anderson (DataCamp) and Dr. Yves Hilpisch (The Python Quants) recently spoke on how AI may be used in finance, how it compares to more traditional approaches, and why data scientists are now important participants in the industry. They also talked about risk and uncertainty, as well as how AI and machine learning can help with market collapses, black swan events, and unpredictable markets.

What is AI and what are the implications?

Artificial intelligence, according to Yves, refers to a wide spectrum of fields that attempt to replicate and improve human abilities. In this sense, AI in chess aims to beat humans in the game, and AI in finance entails developing and training bots that can trade more effectively than humans. Artificial intelligence (AI) is when software performs a task that we would consider intelligent. Intelligence, on the other hand, can be defined as the ability to attain a specific goal. — Yves Hilpisch, Ph.D.

Humans are substantially less efficient at following the scientific method than machines. By tracking what people actually do, they may look at the data and uncover hidden preferences. They gain insights as a result of this. They use millions of data points to come up with these conclusions, which are significantly more accurate than theoretical models.

So what is the scientific method?

You put up an experiment, gather data, and then try to identify data that either supports or contradicts the hypothesis. The next phase will be to tweak your hypothesis, assumptions, or maybe abandon the theory entirely. Machines can duplicate the scientific method a million times in a matter of seconds. — Dr. Yves Hilpisch

In the last 20 years, artificial intelligence has delivered a significant competitive advantage. In banking, AI serves the same aim as it does in every other industry: to achieve a competitive advantage. It all began in finance in the 1950s, when Markowitz pioneered the first quantitative finance model. It was the first widely accepted model in the field of variance portfolio theory. It’s still being used to manage trillions of dollars now. It does, however, use normative theory, which is based on examining many alternative securities portfolios—it is not prescriptive, as it does not prescribe a course of action. As a result, it is based on behavioral or market data rather than data.

Data has been more accessible than ever before in the last 20 years; the trick is to know how to use it effectively. The Man Who Solved the Market, by Gregory Zuckerman, describes how the hedge firm Renaissance Technologies pioneered the use of data for financial advantage. Today, practically every industry has adopted the technique of developing mathematical models and crunching data, and as a result, they are able to make better decisions. Modern quantitative finance application cases and best practices. In the financial markets, artificial intelligence has progressed dramatically. For example, supervised learning algorithms can accurately forecast the behavior of creditors or consumers using the massive amounts of data accessible today. Reinforcement learning is also used in algorithmic trading to reward and punish trading bots based on how much money they gain or lose. We now have millions upon millions of data points with which to examine human behavior. And, because of modern technologies, banks and institutions like fintech companies are ten times, a hundred times better at predicting consumer behavior, creditor behavior, and so on than any theory established by finance professors. —Yves Hilpisch, Ph.D.

However, in times like these, when market volatility is strong, it’s evident that AI in finance necessitates safety procedures. Supervised learning is based on historical data, with the assumption that what has happened in the past will repeat itself in the future. In times of market instability, this is flawed logic. That’s why you need restrictions in place to prevent incorrect trading decisions, such as putting a stop loss on the algorithms, which determines the price at which an asset or commodity will be sold. This approach is similar to placing security systems on a self-driving car to keep it from hitting pedestrians on a sidewalk and limiting losses that are too big to sustain. AI is effective for decreasing the risk associated with current events and their market effects. Guided learning strategies must be closely monitored in black swan events, and reinforcement learning can be employed to retrain models based on new market conditions. For the foreseeable future, human interaction and rigorous monitoring of deployed algorithms will be essential.

The requirement for simple, scalable, and replicable tools The Monte Carlo simulation is a forward-looking approach in computational finance that starts at a specific point in time and simulates outward into the future. Python is an excellent choice for this. Today’s Python data stack is a collection of interoperable packages that let you ingest data, manipulate it with pandas, perform statistical modeling, and build machine learning algorithms. Python makes it possible to do all of this at a large scale. Today, having the right tooling is essential for algorithmic trading. And gaining a job in this business necessitates a basic understanding of these tools—specifically, Python and R. Many individuals have been able to perform things that were previously impossible thanks to the Python module pandas and frameworks like TensorFlow and Keras. Lowering the entrance barriers and learning how to use these technologies is a significant commitment, and more businesses and individuals are making it than ever before. DataCamp and The Python Quants are examples of educational products that can help to democratize the learning process. Learners become familiar with data science and machine learning topics, as well as constructing algorithms in a coding environment on their own. They can also learn how to build up an appropriate environment and toolchain for working on the server, giving them the ability to deploy algorithms on the cloud.