Machine Learning framework for algorithmic trading energy markets

01/05/2019 A Machine Learning framework for an algorithmic trading system
A Machine Learning framework for

Algorithmic trading on
Energy markets
Simon Kuttruf Follow
Jul 16, 2018 · 11 min read
New breakthroughs in AI make the headlines everyday. Far from the buzz
of customer-facing businesses, the wide adoption and powerful
applications of Machine Learning in Finance are less well known. In
fact, there are few domains with as much historical, clean and structured
data as the nancial industry — making it one of those predestined use
cases where ‘learning machines’ made an early mark with tremendous
success that still continues.
About three years ago, I got involved in developing Machine Learning

(ML) models for price predictions and algorithmic trading in Energy
markets, specifically for the European market of Carbon emission
certificates. In this article, I want to share some of the learnings,
approaches and insights which I have found relevant in all my ML
projects since. Rather than on technical detail, my focus here is on the
general considerations behind modelling choices which are discussed
rarely in the classical academic textbooks or online tutorials on new
techniques. — On the example of algorithmic trading, I present some
‘tricks of the trade’ which you might find useful when applying
Machine Learning to real-life contexts in the vast world beyond
https://towardsdatascience.com/https-medium-com-skuttruf-machine-learning-in-finance-algorithmic-trading-on-energy-markets-cb68f7471475 1/11
synthetique examples, as a lonely seeker or with your team of fellow

data scientists.
The Context
The market of European Carbon Emission Certificates (EU ETS) has

been established in the wake of the Kyoto Protocol 2005 as a major
pillar of EU climate policy, regulating about half of Europe’s
anthropogenic CO2 emissions by a scheme of ‘cap and trade’. This
mechanism provides national governments with control over the total
amount of greenhouse gas emissions (‘cap’) while conceding the
efficient allocation of emission rights to market forces (‘trade’). The
basic idea is to put a price on pollution: each industrial installation
covered in the scheme has to monitor and report its exact quantity of
greenhouse gas emissions to the authorities and then offset the
respective amount (measured in tons) by handing in allowances. These
‘rights to pollution’ are auctioned off or given for free to the industrial
players, and can then be traded over-the-counter or on a central market
for prices flexibly set by demand and supply. With overall supply of
yearly permits constrained by the reduction targets of the
environmental policy, some polluters are compelled to opt for measures
reducing their pollution (‘abatement’), eg by installing additional filters
in their chimneys. These polluters with marginal abatement costs lower
than the current market price of permits (eg because their specific filter
requirements are cheap) can then sell their excess pollution allowances
on the market for a profit, to polluters facing higher marginal
abatement costs. In a perfectly efficient emissions trading market, the
equilibrium price of permits would settle at the marginal abatement
cost of the final unit of abatement required to meet the overall
reduction target set by the cap on the supply of permits.
Given the uncertainty about the actual industry-specific abatement

costs, this instrument lets governments control the total amount of
emissions, while the actual price of emission permits fluctuates
according to demand-side market forces, namely
· market expectations about future policy changes
· the size of upcoming permit auctions, price and cover ratio of ongoing
auctions (see Figure 1)
· speculation of market participants
· banking behaviour (permits issued in one year are valid for all years in
the same policy phase)
· the price relations of other energy commodities.
To exemplify the latter, suppose the price of natural gas per calorific
unit drops below the price of brent oil. Power producers and utilities
would switch over to this less carbon intense fuel, thus lowering the
demand for carbon allowances. Accordingly, the price of allowances
would drop as well in those periods (see Figure 2).
Figure 1: Bullish signal from a highly covered auction at 2pm shortly breaking a bearish trend
Figure 2: Positive 30day correlation of EUA with UK Gas in 2017 (absolute and normalized)
A comprehensive model needs to reflect all these factors. While we can

safely assume that patterns observed in the abundant historical market
data carry over into the present and will continue into the future (this
is actually the sine qua non, the indispensable assumption for any
analytical modelling), it is obvious that this setting is too complex for
any approach trying to model the market based on generic beliefs,
fundamental relations or state space concepts from Econophysics.
. . .
So this is really a use case to unleash the power of Machine Learning.

How to leverage it?
Here is a typical workflow for a trading system using supervised

learning:
1. Data
Get the data in place. Good sources for financial time series are the API
of the exchange you want to trade on, the APIs of AlphaVantage or
Quandl. The scale of the data should at least be as fine as the scale you
want to model and ultimately predict. What is your forecast horizon?
Longer-term horizons will require additional input factors like market
publications, policy outlooks, sentiment analysis of twitter revelations
etc. If you are in for the game of short-term or even high-frequency
trading based on pure market signals from tick data, you might want to
include rolling averages of various lengths to provide your model with
historical context and trends, especially if your learning algorithm does
not have explicit memory cells like Recurrent Neural Networks or
LSTMs. All common indicators used in technical analysis (eg RSI, ADX,
Bollinger Bands, MACD) are based on some sort of moving averages of
some quantity (price, trading volume) — even if you don’t believe in
simplistic trading rules, including them will help the model to reflect
trading behaviour of a majority of market participants. Your
computational capacity might be a limiting factor, especially in a
context where your ML model will be up against hard-coded, fast and
unique-purpose algorithms of market-making or arbitrage seekers.
Deploying dedicated cloud servers or ML platforms like H2O and
TensorFlow allows you to spread computation over various servers.
Clean the data (how do you interpolate gaps?), chart it, play with it —
do you already spot trading opportunities, trends, anomalies?
2. Supervised Model Training
Split your data into complementary sets for training, validation (for
parameter tuning, feature selection etc) and testing. This is actually
more complex than it sounds: optimally, the test set should be as
‘similar’ as possible to the present ‘state of the market’, and both
validation and test set should follow the same distribution. Otherwise
you might waste effort tuning the model parameters on the validation
set only to find that it poorly generalizes to the test set. Following the
concept of ‘market regimes’ — ie extended periods where a specific
combination of commodities dominates the price dynamics of your
target instrument — it might be worthwhile to first have a clustering
algorithm of unsupervised learning discover defining correlations in
the data and then evaluate model performance on data in the
validation and test set belonging to the same clusters (see Figure 3 — in
this project, clustering increased predictive performance by 8%).
Figure 3 Coherent market periods as identi ed by a clustering algorithm (colored segments of EUA
settle price)
Early on, decide on and establish a single-number evaluation metric.

Chasing too many different metrics will only lead to confusion. In the
context of algorithmic trading, a suitable measure is ‘Profit and Loss’
(PnL) as it weights classification precision (price up/down) with the
actual size of the swing (‘relevance’). And it fits with the metrics you
may consider for your Trading Policy. Observe the model performance
on training and validation set. If error on the training set, ie ‘model
bias’, is high, you may need to allow for more model parameters (eg by
adding more layers/neurons in a deep learning model). If the model
poorly generalizes (‘the model is overfitting to the training set’), that is
performance difference on validation and training set (‘model
variance’) is high, you may need to add more data to the training set,
reduce the number of features to the most relevant ones, add
regularization (eg L2, L1 or dropout) or early stopping (in the gradient
descent optimization). Examining closely the cases where the model
went wrong will help to identify any potential and avoidable model
bias, see Figure 4.
Figure 4 Error analysis — price move versus forecast con dence (>0.5: up, <0.5: down)
Establish your target performance: for market forecasts, a

classification precision of 75% is actually quite good — it is 50% better
than random guessing (50% precision). This baseline is very different
to other ML applications like object or speech recognition which
operate in a closed environment where the factors affecting the
modelling target can be clearly identified (the RGB channels of image
pixels, the wave frequencies of sound samples).
3. Trading Policy
Define your trading policy: a set of rules defining the concrete trading
implications of the model outputs: eg depending on a threshold for
the model confidence of a given prediction, what position do you place
on the market, what position size, for how long do you hold a position
in the given state of the market etc. A policy usually comes with some
more free parameters which need to be optimized (next step). In the
context of supervised learning discussed here, this is a fairly manual
process based on backtesting and grid search (some shortcomings
outlined below).
4. Backtesting & Optimization
Now it gets down to the numbers — how well is your trading system, or
the interplay of prediction models and a given trading policy,
performing on a hold-out set of historical market data? Here the test
set used in step 2 (model training) can become the validation set for
tuning the parameters of the policy. Genetic algorithms allow you to
explore the policy space, starting from a first generation of say 100
randomly chosen policy parameters, iteratively eliminating the 80
worst performers and making the 20 survivors produce 4 offspring
each. Or you can employ a grid search in the multidimensional

parameter space: starting from some plausible values for the
parameters of the policy, what is the best-performing setting you can
achieve by varying the parameter values one-by-one. Your performance
metric here is the one you finally aim to optimize in your trading
strategy, eg the PnL or some derived quantity like Return on
Investment, SharpeRatio (the return per volatility risk), Value at Risk,
the beta etc, see Figure 5.
Figure 5 PnL and Sharpe Ratio for various trading policies
A good measure to prevent overfitting the parameters to the validation

set is a cross-validation with a ‘walk-forward-test’ (WTF) verifying the
robustness of your approach: optimize the policy parameters on a
validation segment, test them forward in time on data following the
validation segment, shift the validation segment forward to include
that test data, repeat. The basic assumption here is that the recent past
is a better gauge for the future than the more distant past.
5. Simulation & Live Trading
Before your strategy goes live, freeze all system parameters and test
in real-time as if actually placing your orders according to the outputs
of your trading algorithm. This important step is called paper trading
and is the crucial litmus test for the validity of your approach. You
might notice here that in your historical data you have actually used
values which are not really available at a given time, eg when
calculating moving averages. If your strategy still looks promising,
congratulations — it’s time to go live! While you might start by placing
your orders manually, do not underestimate both the administrative
and technical efforts it takes to integrate your strategy with the API of
your exchange.
. . .
The typical workflow presented here has some severe shortcomings:
· For derivative contracts, like futures on an underlying, historical data

usually reports the open and close price of a day or a chosen time
interval and a settle price which is about the average price of the
contracts in all deals realized in the interval. But this is unlikely to be
the price for which you can clear your buy or sell order, depending on
the dynamics of order books which have different volumes at various
bid/ask price levels. So your model predictions from step 2 do refer to a
theoretical price but likely not to the price you will place your bets on. A
more detailed modelling approach would need to take into account the
actual structure and dynamics of order books.
· Developing the policy (step 3) is not part of the Machine Learning

based modelling but a manual process guided by intuition, experience
or just simple heuristics. Eg you would place a buy order (‘go long’)
when the model predicts a price increase. But how many contracts do
you buy? What confidence threshold do you use? How long do you
hold your position in the face of adverse market conditions?
· Feedback comes late: you need to undergo steps 1–3 before you get a
first indication about the performance of your strategy. Parameters of
the prediction model and the policy are optimized independently
even if model and policy actually interact closely. Exploring the
space of policy parameters in this framework is done via inefficient
numerical optimisation, not with the powerful gradient optimization of
your predictive Machine Learning model.
The framework of Reinforcement Learning integrates steps 2 and 3

above, modelling trading as the interaction of an agent (trader) with
the environment (market, order books) to optimize a reward (eg
return) by its actions (placing orders). While still at an early stage,
recent research indicates that this is a route worth exploring — “further
studies need to be done”.
References:
See Wikipedia, Emissions Trading for an extensive discussion of the

‘cap and trade’ mechanism and Wikipedia, EU ETS for more specific
information about the European market framework.
S.Smith, Environmental Economics (Oxford University Press 2011)

provides a great introduction into the history and implications of
market approaches to environmental policies.
Denny Britz’ blog post gives more detail on the mechanics of order
books and the prospects of Reinforcement Learning approaches in
Algorithmic Trading.
Disclaimer: The project outlined above was undertaken for and with
Abatement Capital LLC, a proprietary investment and trading firm
focused on carbon and other environmental commodities, who agreed
with this publication in the current form. The responsibility for all
content and views expressed in this article is solely with the author.
The author: A passionate data scientist, I have worked as the tech lead
for startups across the globe and implemented real-life AI solutions for
the last four years. Contact me at simon@deepprojects.de.

Machine Learning framework for algorithmic trading energy markets

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01/05/2019 A Machine Learning framework for an algorithmic trading system

A Machine Learning framework for

About three years ago, I got involved in developing Machine Learning

synthetique examples, as a lonely seeker or with your team of fellow

The market of European Carbon Emission Certificates (EU ETS) has

Given the uncertainty about the actual industry-specific abatement

· market expectations about future policy changes

· speculation of market participants

· the price relations of other energy commodities.

A comprehensive model needs to reflect all these factors. While we can

So this is really a use case to unleash the power of Machine Learning.

Here is a typical workflow for a trading system using supervised

2. Supervised Model Training

Early on, decide on and establish a single-number evaluation metric.

Establish your target performance: for market forecasts, a

4. Backtesting & Optimization

each. Or you can employ a grid search in the multidimensional

Figure 5 PnL and Sharpe Ratio for various trading policies

A good measure to prevent overfitting the parameters to the validation

5. Simulation & Live Trading

The typical workflow presented here has some severe shortcomings:

· For derivative contracts, like futures on an underlying, historical data

· Developing the policy (step 3) is not part of the Machine Learning

The framework of Reinforcement Learning integrates steps 2 and 3

See Wikipedia, Emissions Trading for an extensive discussion of the

information about the European market framework.

S.Smith, Environmental Economics (Oxford University Press 2011)

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