Trading the FX volatility risk premium with machine learning and alternative data

Abstract

In this study, we show how both machine learning and alternative data can be successfully leveraged to improve and develop trading strategies. Starting from a trading strategy that harvests the EUR/USD volatility risk premium by selling one-week straddles every weekday, we present a machine learning approach to more skillfully time new trades and thus prevent unfavorable ones. To this end, we build probability-calibrated Random Forests on various predictors, extracted from both traditional market data and financial news, to predict the closing Sharpe ratio of short one-week delta-hedged straddles. We then demonstrate how the output of these calibrated machine learning models can be used to engineer intuitive new trading strategies. Ultimately, we show that our proposed strategies outperform the original strategy on risk-based performance measures. Moreover, the features that we derived from financial news articles significantly improve the performance of the approach.