AuthorDerek Melchin2020-11-19

Abstract

Naïve Bayes models have become popular for their success in spam email filtering. In this tutorial, we train Gaussian Naïve Bayes (GNB) classifiers to forecast the daily returns of stocks in the technology sector given the historical returns of the sector. Our implementation shows the strategy has a greater Sharpe and lower variance than the SPY ETF over a 5 year backtest and during the 2020 stock market crash. The algorithm we build here follows the research done by Lu (2016) and Imandoust & Bolandraftar (2014).

Background

Naïve Bayes models classify observations into a set of classes by utilizing Bayes’ Theorem

In symbols, this translates to

where represents one of the classes and are the features.

The Naïve Bayes model assumes the features are independent, so that

The class that is most probable given the observation is then determined by solving

In our use case, the classes in the model are: positive, negative, or flat future return for a security. The features are the last 4 daily returns of the universe constituents. Since we are dealing with continuous data, we extend the model to a GNB model by replacing in the equation above. First, we find the mean and standard deviation of the feature vector in the training set labeled class . A normal distribution parameterized by and is then used to determine the likelihood of the observations. If is the observation for the th feature. The likelihood of the observation given the class is

The mechanics of the GNB model can be seen visually in this video. Note that the GNB model has 2 underlying assumptions: the feature vectors are independent and normally distributed. We do not test for these properties, but rather leave it as an area of future research.

Video Walkthrough

Method

Universe Selection

Following Lu (2016), we implement a custom universe selection model to select the largest stocks from the technology sector. We restrict our universe to have a size of 10, but this can be easily customized via the fine_size parameter in the constructor.

class BigTechUniverseSelectionModel(FundamentalUniverseSelectionModel):
    def __init__(self, fine_size=10):
        self.fine_size = fine_size
        self.month = -1
        super().__init__(True)

    def SelectCoarse(self, algorithm, coarse):
        if algorithm.Time.month == self.month:
            return Universe.Unchanged
        return [ x.Symbol for x in coarse if x.HasFundamentalData ]

    def SelectFine(self, algorithm, fine):
        self.month = algorithm.Time.month

        tech_stocks = [ f for f in fine if f.AssetClassification.MorningstarSectorCode == MorningstarSectorCode.Technology ]
        sorted_by_market_cap = sorted(tech_stocks, key=lambda x: x.MarketCap, reverse=True)
        return [ x.Symbol for x in sorted_by_market_cap[:self.fine_size] ]

Alpha Construction

The GaussianNaiveBayesAlphaModel predicts the direction each security will move from a given day’s open to the next day’s open. When constructing this Alpha model, we set up a dictionary to hold a SymbolData object for each symbol in the universe and a flag to show the universe has changed.

class GaussianNaiveBayesAlphaModel(AlphaModel):
    symbol_data_by_symbol = {}
    new_securities = False

Alpha Securities Management

When a new security is added to the universe, we create a SymbolData object for it to store information unique to the security. The management of the SymbolData objects occurs in the Alpha model's OnSecuritiesChanged method. In this algorithm, since we train the Gaussian Naive Bayes classifier using the historical returns of the securities in the universe, we flag to train the model every time the universe changes.

class GaussianNaiveBayesAlphaModel(AlphaModel):
    ...

    def OnSecuritiesChanged(self, algorithm, changes):
        for security in changes.AddedSecurities:
            self.symbol_data_by_symbol[security.Symbol] = SymbolData(security, algorithm)

        for security in changes.RemovedSecurities:
            symbol_data = self.symbol_data_by_symbol.pop(security.Symbol, None)
            if symbol_data:
                symbol_data.dispose()

        self.new_securities = True

SymbolData Class

The SymbolData class is used to store training data for the GaussianNaiveBayesAlphaModel and manage a consolidator subscription. In the constructor, we specify the training parameters, setup the consolidator, and warm up the training data.

class SymbolData:
    def __init__(self, security, algorithm, num_days_per_sample=4, num_samples=100):
        self.exchange = security.Exchange
        self.symbol = security.Symbol
        self.algorithm = algorithm
        self.num_days_per_sample = num_days_per_sample
        self.num_samples = num_samples
        self.previous_open = 0
        self.model = None

        # Setup consolidators
        self.consolidator = TradeBarConsolidator(timedelta(days=1))
        self.consolidator.DataConsolidated += self.CustomDailyHandler
        algorithm.SubscriptionManager.AddConsolidator(self.symbol, self.consolidator)

        # Warm up ROC lookback
        self.roc_window = np.array([])
        self.labels_by_day = pd.Series()

        data = {f'{self.symbol.ID}_(t-{i})' : [] for i in range(1, num_days_per_sample + 1)}
        self.features_by_day = pd.DataFrame(data)

        lookback = num_days_per_sample + num_samples + 1
        history = algorithm.History(self.symbol, lookback, Resolution.Daily)
        if history.empty or 'close' not in history:
            algorithm.Log(f"Not enough history for {self.symbol} yet")    
            return

        history = history.loc[self.symbol]
        history['open_close_return'] = (history.close - history.open) / history.open

        start = history.shift(-1).open
        end = history.shift(-2).open
        history['future_return'] = (end - start) / start

        for day, row in history.iterrows():
            self.previous_open = row.open
            if self.update_features(day, row.open_close_return) and not pd.isnull(row.future_return):
                row = pd.Series([np.sign(row.future_return)], index=[day])
                self.labels_by_day = self.labels_by_day.append(row)[-self.num_samples:]

The update_features method is called to update our training features with the latest data passed to the algorithm. It returns True/False, representing if the features are in place to start updating the training labels.

class SymbolData:
    ...

    def update_features(self, day, open_close_return):
        self.roc_window = np.append(open_close_return, self.roc_window)[:self.num_days_per_sample]

        if len(self.roc_window) < self.num_days_per_sample:
            return False

        self.features_by_day.loc[day] = self.roc_window
        self.features_by_day = self.features_by_day[-(self.num_samples+2):]
        return True

Model Training

The GNB model is trained each day the universe has changed. By default, it uses 100 samples to train. The features are the historical open-to-close returns of the universe constituents. The labels are the returns from the open at to the open at at each time step for each security.

class GaussianNaiveBayesAlphaModel(AlphaModel):
    ...

    def train(self):
        features = pd.DataFrame()
        labels_by_symbol = {}

        # Gather training data
        for symbol, symbol_data in self.symbol_data_by_symbol.items():
            if symbol_data.IsReady:
                features = pd.concat([features, symbol_data.features_by_day], axis=1)
                labels_by_symbol[symbol] = symbol_data.labels_by_day

        # Train the GNB model
        for symbol, symbol_data in self.symbol_data_by_symbol.items():
            if symbol_data.IsReady:
                symbol_data.model = GaussianNB().fit(features.iloc[:-2], labels_by_symbol[symbol])

Alpha Update

As new TradeBars are provided to the Alpha model's Update method, we collect the open-to-close return of the latest TradeBar for each security in the universe. We then predict the direction of each security using the security’s corresponding GNB model, and return Insight objects accordingly.

class GaussianNaiveBayesAlphaModel(AlphaModel):
    ...

    def Update(self, algorithm, data):
        if self.new_securities:
            self.train()
            self.new_securities = False

        tradable_symbols = {}
        features = [[]]

        for symbol, symbol_data in self.symbol_data_by_symbol.items():
            if data.ContainsKey(symbol) and data[symbol] is not None and symbol_data.IsReady:
                tradable_symbols[symbol] = symbol_data
                features[0].extend(symbol_data.features_by_day.iloc[-1].values)

        insights = []
        if len(tradable_symbols) == 0:
            return []
        weight = 1 / len(tradable_symbols)
        for symbol, symbol_data in tradable_symbols.items():
            direction = symbol_data.model.predict(features)
            if direction:
                insights.append(Insight.Price(symbol, data.Time + timedelta(days=1, seconds=-1), 
                                              direction, None, None, None, weight))

        return insights

Portfolio Construction & Trade Execution

We utilize the InsightWeightingPortfolioConstructionModel and the ImmediateExecutionModel.

Relative Performance

Period Name Start Date End Date Strategy Sharpe Variance
5 Year Backtest 10/1/2015 10/13/2020 Strategy 0.011 0.013
Benchmark 0.729 0.024
2020 Crash 2/19/2020 3/23/2020 Strategy -1.433 0.236
Benchmark -1.467 0.416
2020 Recovery 3/23/2020 6/8/2020 Strategy -0.156 0.028
Benchmark 4.497 0.072

Conclusion

To continue the development of this strategy, future areas of research include:

  • Adjusting parameters in the SymbolData class
  • Trying other features and labels for the GNB model
  • Adjusting the universe parameters and targeted sector
  • Adding handlers for corporate actions
  • Filter for stocks with independent and normal returns

Algorithm



Reference

  1. Imandoust, S. B., & Mohammad, B. (2014). Forecasting the direction of stock market index movement using three data mining techniques: the case of Tehran Stock Exchange. Journal of Engineering Research and Applications, 6(2), 106-117. Online copy
  2. Lu, N. (2016). A Machine Learning Approach to Automated Trading. Online copy

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