Chris Donnan : Programming – Brooklyn Style

13/04/2008

Using Artificial Immune Systems (AISs) to find mis-priced options

Here is a quickie primer on AISs or immune system inspired algorithms. Essentially AISs do a good job of figuring out what is ‘itself’ or ‘normal’ and what is ‘non-self’, ‘alien’ or ‘abnormal’ in a system. Antigens are components that find pathogens (antigens find patterns that are normal to them, the non-normal things then are pathogens).

Some ~2 or 3 years ago, MIT’s Journal of Evolutionary Computation had a ‘special issue’ on AISs. There were several interesting publications in that particular issue, and it led me on a minor reading splurge regarding AISs. At the time, I had been heavily focused on evolutionary and other bio-inspired algorithms and their applications for automated trading systems. There are a ton of algorithms in this class, many of them have mappings to various sub-problems in automated trading.

As far as I can find, there is no work out there currently that applies AISs to finding mis-priced options, and it seems quite a good fit. Searching over a sea of options to sort out which one seem to be aberrations may be a good match. AISs are relatively efficient algorithms compared to alternatives. Interestingly – it would not even necessarily involve your own option pricing model – you would be basically letting the AIS sort out what seem to be ‘normal’ pricings and what seem to stand out as odd.

This is obviously one component of the puzzle, sorting out if the option should be bought or sold is another component. This particular technique could also be applied to any other derivative market with ample liquidity, not just options.

Just some nonsense that has been meandering around my brain for a week or so, so I figured I would write it up here.

-Chris

Filed under: AI/ Machine Learning,algorithmic trading — chrisdrop @ 12:05

Portfolio Insurance Caused the ’87 Crash

I am reading an interesting and timely book on the current credit crisis; The Trillion Dollar Meltdown. I will update with my thoughts on the book when I am done with it, but I wanted to comment on 1 particular element presently…

trillion dollar meltdown

There have been several theories on why the 1987 crash happened, but it seems that at least 2 books agree that it was due to ‘everybody using Portfolio Insurance’. The other book was Bookstabber’s Demons of our Own Design (which I quite enjoyed). Essentially, some smart folks came up with portfolio insurance. It worked well for them, they started selling it as a service to other firms. Soon enough, everybody was doing it. When the portfolios started hitting their floors, there was a fantastic circular reaction between markets that were now interconnected via portfolio insurance programs all over the street. Downward spiral ensues. Money disappears, etc.

I just thought it was noteworthy that this is the 2nd book that said outright that the basic issue was primarily portfolio insurance.

-Chris

PS – I am wondering if CPPI (zero coupon bonds usually involved) vs the futures technique referred to in the case of the ’87 crash are the same? Is CPPI an evolution of that portfolio insurance? Always more to learn.

Filed under: Finance,trading — chrisdrop @ 11:52

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