An adaptive portfolio trading system: A risk-return portfolio optimization using recurrent reinforcement learning with expected maximum drawdown. (30th November 2017)

• Record Type: Journal Article
• Authors: Almahdi, Saud; Yang, Steve Y.
• Is Part Of: Expert systems with applications. Volume 87(2017)
• Page Start: 267
• Page End: 279
• Publication Date: 2017-11-30
• Subjects: Recurrent reinforcement learning -- Expected maximum drawdown -- Optimal portfolio rebalancing -- Downside risk; Expert systems (Computer science) -- Periodicals; Systèmes experts (Informatique) -- Périodiques; Electronic journals; 006.33
• DOI: 10.1016/j.eswa.2017.06.023
• Languages: English
• ISSNs: 0957-4174

Abstract

Highlights: A reinforcement learning trading algorithm with expected drawdown risk is proposed. The expected maximum drawdown is shown to improve portfolio signal generation. The effectiveness of the method is validated using different transaction costs. An adaptive portfolio rebalancing system with automated retraining is recommended. Abstract: Dynamic control theory has long been used in solving optimal asset allocation problems, and a number of trading decision systems based on reinforcement learning methods have been applied in asset allocation and portfolio rebalancing. In this paper, we extend the existing work in recurrent reinforcement learning (RRL) and build an optimal variable weight portfolio allocation under a coherent downside risk measure, the expected maximum drawdown, E(MDD). In particular, we propose a recurrent reinforcement learning method, with a coherent risk adjusted performance objective function, the Calmar ratio, to obtain both buy and sell signals and asset allocation weights. Using a portfolio consisting of the most frequently traded exchange-traded funds, we show that the expected maximum drawdown risk based objective function yields superior return performance compared to previously proposed RRL objective functions (i.e. the Sharpe ratio and the Sterling ratio), and that variable weight RRL long/short portfolios outperform equal weight RRL long/short portfolios under different transaction cost scenarios. We further propose an adaptive E(MDD) risk based RRL portfolio rebalancing decision system with a transaction cost and market condition stop-loss retraining mechanism, and we show that the proposed portfolio trading system responds to transaction cost effects better and outperforms hedge fund benchmarks consistently.