Trading Algorithms with Learning in Latent Alpha Models

38 Pages Posted: 28 May 2020

See all articles by Philippe Casgrain

Philippe Casgrain

University of Toronto - Department of Statistics

Sebastian Jaimungal

University of Toronto - Department of Statistics

Multiple version iconThere are 2 versions of this paper

Date Written: July 2019

Abstract

Alpha signals for statistical arbitrage strategies are often driven by latent factors. This paper analyzes how to optimally trade with latent factors that cause prices to jump and diffuse. Moreover, we account for the effect of the trader's actions on quoted prices and the prices they receive from trading. Under fairly general assumptions, we demonstrate how the trader can learn the posterior distribution over the latent states, and explicitly solve the latent optimal trading problem. We provide a verification theorem, and a methodology for calibrating the model by deriving a variation of the expectation–maximization algorithm. To illustrate the efficacy of the optimal strategy, we demonstrate its performance through simulations and compare it to strategies that ignore learning in the latent factors. We also provide calibration results for a particular model using Intel Corporation stock as an example.

Keywords: algorithmic trading, latent alpha, machine learning, partial information, statistical arbitrage, stochastic control

JEL Classification: G11, C61, C40

Suggested Citation

Casgrain, Philippe and Jaimungal, Sebastian, Trading Algorithms with Learning in Latent Alpha Models (July 2019). Mathematical Finance, Vol. 29, Issue 3, pp. 735-772, 2019, Available at SSRN: https://ssrn.com/abstract=3613159 or http://dx.doi.org/10.1111/mafi.12194

Philippe Casgrain (Contact Author)

University of Toronto - Department of Statistics ( email )

100 St George Street
Toronto, Ontario M5S 3G8
Canada

Sebastian Jaimungal

University of Toronto - Department of Statistics ( email )

100 St. George St.
Toronto, Ontario M5S 3G3
Canada

HOME PAGE: http://http:/sebastian.statistics.utoronto.ca

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