This is the third installment of the series. Part I, titled “Reducing the Risk of Risk Management,” explores how a passive overlay can assist independent advisors and investors in utilizing options to manage downside risk in their portfolios. In Part II, “A Lower Risk Option for Options: Passive Risk Management,” Sun explains how his firm has automated options trading to provide a form of ‘passive’ portfolio protection.
Philip Sun starts the conversation by differentiating between machine learning AI (ML AI), the form discussed in his book, Hands-On AI Trading with Python, QuantConnect, and AWS, and generative AI, which he believes introduces both a new kind of value and a new kind of risk.
“At its core, finance is an information science, and trading is one of its practical applications. From that perspective, a company is just a piece of information. Any technology that systematically evaluates and analyzes that information in a new way will quickly be adopted by the investment world. You can think of ML AI as rocket fuel that brought us all the way from manual intuition to systematic mathematical and scientific analysis, greatly expanding the scope of information processing. I see no risk in that – it just makes the market more efficient.”
Generative AI, says Sun, is different.
“Where traditional data analysis and ML AI are largely regression-based and reactive, Generative AI acts in real-time and is proactive. That means it could potentially be used to manipulate the markets. Anecdotally, it’s already being used in social media to shift public opinion.”
Sun believes that in its current form Generative AI would ideally be limited to a service role in finance, perhaps creating new educational resources and helping advisors and investors devise better strategies and identify more precise investment opportunities.
“If you train a Generative AI agent on honest data and proven solutions it can potentially deliver better recommendations because it has instant access to a much wider spectrum of tools than an investor or advisor could leverage on their own. It can innovate, though when I say ‘innovate’ I don’t mean breakthrough innovation. I mean, for example, it can be trained to think carefully about an investor’s practical constraints and goals and find ways to fill gaps that might otherwise be overlooked.”
Sun also sees applications in systematic trading, where ML AI currently excels.
“I teach a class in high-frequency trading, which is largely driven by ML AI. It’s all about fast technical pattern detection, low latency and trade execution, and at today’s speeds there’s no way a human being could keep up.”
ML AI analyzes inputs and generates rule-based strategies which it can change quickly and frequently. The limitation, Sun points out, is that ML AI can only act after it receives inputs, not in real-time. And ML AI will only stick to the rules and game plans encoded ahead of time.
“By comparison, Generative AI can act in real-time, where it could help algorithms become even more sensitive to small shifts, instantly fine-tuning trading policies and strategies and introducing new responses and rule-changes. Ultimately, these systems could become true trading agents.”
But, Sun cautions, real-time is also where the specter of market manipulation looms largest.
“Systematic manipulation would be an order of magnitude more consequential than is currently possible. Front-running, for example, raises legal and ethical issues, indeed, but also increases market efficiency and liquidity. But if you start embedding hostile Generative AI tools in trading strategies you could potentially destroy the markets. Of course you could also use it to detect and reverse manipulations — but that would become an arms race, similar to the ongoing battle against malicious computer viruses. There’s plenty of positive potential too, but we’ll just have to see what happens.”
Disclosure: Interactive Brokers
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Disclosure: Options Trading
Options involve risk and are not suitable for all investors. Multiple leg strategies, including spreads, will incur multiple commission charges. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD) or visit ibkr.com/occ
