# The Frequency Effect Part III: Revelations of Multi-Bandpass Filters and Signal Extraction for Financial Trading

Animation of the out-of-sample performance of one of the multibandpass filters built in this article for the daily returns of the price of Google. The resulting trading signal was extracted and yielded a trading performance near 39 percent ROI during an 80 day out-of-sample period on trading shares of Google.

To conclude the trilogy on this recent voyage through various variations on frequency domain configurations and optimizations in financial trading using MDFA and iMetrica, I venture into the world of what I call multi-bandpass filters that I recently implemented in iMetrica.  The motivation of this latest endeavor in highlighting the fundamental importance of the spectral frequency domain in financial trading applications was wanting to gain better control of extracting signals and engineering different trading strategies through many different types of market movement in financial assets. There are typically four different basic types of movement a price pattern will take during its fractalesque voyage throughout the duration that an asset is traded on a financial market. These patterns/trajectories include

1. steady up-trends in share price
2. low volatility sideways patterns (close to white noise)
3. highly volatile sideways patterns (usually cyclical)
4. long downswings/trends in share price.

Using MDFA for signal extraction in financial time series, one typically indicates an a priori trading strategy through the design of the extractor, namely the target function $\Gamma(\omega)$ (see my previous two articles on The Frequency Effect). Designating a lowpass or bandpass filter in the frequency domain will give an indication of what kind of patterns the extracted trading signal will trade on. Traditionally one can set a lowpass with the goal of extracting trends (with the proper amount of timeliness prioritized in the parameterization), or one can opt for a bandpass to extract smaller cyclical events for more systematic trading during volatile periods. But now suppose we could have the best of both worlds at the same time. Namely, be profitable in both steady climbs and long tumbles, while at the same time systematically hacking our way through rough sideways volatile territory, making trades at specific frequencies embedded in the share price actions not found in long trends. The answer is through the construction of multi-band pass filters. Their construction is relatively simple, but as I will demonstrate in this article with many examples, they are a bit more difficult to pinpoint optimally (but it can be done, and the results are beautiful… both aesthetically and financially).

With the multi-bandpass defined as two separate bands given by $A := 1_{[\omega_0, \omega_1]}$$B := 1_{[\omega_2, \omega_3]}$ with $0 \leq \omega_0$ and $\omega_1 < \omega_2$, zero everywhere else, it is easy to see that the motivation here is to seek a detection of both lower frequencies and low-mid frequencies in the data concurrently. With now up to four cutoff frequencies to choose from, this adds yet another few wrinkles in the degrees of freedom in parameterizing the MDFA setup. If choosing and optimizing one cutoff frequency for a simple low-pass filter in addition to customization and regularization parameters wasn’t enough, now imagine extracting signals with the addition of up to three more cutoff frequencies. Despite these additional degrees of freedom in frequency interval selection, I will later give a couple of useful hacks that I’ve found helpful to get one started down the right path toward successful extraction.

With this multi-bandpass definition for $\Gamma$ comes the responsibility to ensure that the customization of smoothness and timeliness is adjusted for the additional passband. The smoothing function $W(\omega; \alpha)$ for $\alpha \geq 0$ that acts on the periodogram (or discrete Fourier transforms in multivariate mode) is now defined piecewise according to the different intervals $[0,\omega_0]$, $[\omega_1, \omega_2]$, and $[\omega_3, \pi]$.  For example, $\alpha = 20$ gives a piecewise quadratic weighting function (an example shown in Figure 1) and for $\alpha = 10$, the weighting function is piecewise linear. In practice, the piecewise power function smooths and rids of unwanted frequencies in the stop band much better than using a piecewise constant function. With these preliminaries defined, we now move on to the first steps in building and applying multiband pass filters.

Figure 1: Plot of the Piecewise Smoothing Function for alpha = 15 on a mutli-band pass filter.

To motivate this newly customized approach to building financial trading signals, I begin with a simple example where I build a trading signal for the daily share price of Google. We begin with a simple lowpass filter defined by $\Gamma(\omega) = 1$ if $\omega \in [0,.17]$, and 0 otherwise. This formulation, as it includes the zero frequency, should provide a local bias as well as extract very slow moving trends. The trick with these filters for building consistent trading performance is ensure a proper grip on the timeliness characteristics of the filter in a very low and narrow filter passage. Regularization and smoothness using the weighting function shouldn’t be too much of a problem or priority as typically just only a small fraction of the available degrees of freedom on the frequency domain are being utilized, so not much concern for overfitting as long as you’re not using too long of a filter.  In my example, I maxed out the timeliness $\lambda$ parameter and set the $\lambda_{smooth}$ regularization parameter to .3. Fortunately, no optimization of any parameter was needed in this example, as the performance was spiffy enough nearly right after gauging the timeliness parameter $\lambda$. Figure 2 shows the resulting extracted trend trading signal in both the in-sample portion (left of the cyan colored line) and applied to 80 out-of-sample points (right of the cyan line, the most recent 80 daily returns of Google, namely 9-29-12 through today, 1-10-13). The blue-pink line shows the progression of the trading account, in return-on-investment percentage. The out-of-sample gains on the trades made were 22 percent ROI during the 80 day period.

Figure 2: The in-sample and out-of-sample gains made by constructing a low-pass filter employing a very high timeliness parameter and small amount of regularization in smoothness. The out-of-sample gains are nearly 30 percent and no losses on any trades.

Although not perfect, the trading signal produces a monotonic performance both in-sample and out-of-sample, which is exactly what you strive for when building these trend signals for trading. The performance out-of-sample is also highly consistent (in regards to trading frequency and no losses on any trades) with the in-sample performance. With only 4 trades being made, they were done at very interesting points in the trajectory of the Google share price. Firstly, notice that the local bias in the largest upswing is accounted for due to the inclusion of frequency zero in the low pass filter. This (positive) local bias continues out-of-sample until, interestingly enough, two days before one of the largest losses in the share price of Google over the past couple years. A slightly earlier exit out of this long position (optimally at the peak before the down turn a few days before) would have been more strategic; perhaps further tweaking of various parameters would have achieved this, but I happy with it for now. The long position resumes a few days after the dust settles from the major loss, and the local bias in the signal helps once again (after trade 2). The next few weeks sees shorter downtrending cyclical effects, and the signal fortunately turns positively increasingly right before another major turning point for an upswing in the share price. Finally, the third transaction ends the long position at another peak (3), perfect timing. The fourth transaction (no loss or gain) was quickly activated after the signal saw another upturn, and thus is now in the long position (hint: Google trending upward).  Figure 3 shows the transfer functions $\hat{\Gamma}$ for both the sets of explanatory log-return data and Figure 4 depicts the coefficients for the filter. Notice that in the coefficients plot, much more weight is being assigned to past values of the log-return data with extreme (min and max values) at around lags 15 and 30 for the GOOG coefficients (blue-ish line). The coefficients are also quite smooth due to the slight amount of smooth regularization imposed.

Figure 3: Transfer functions for the concurrent trend filter applied to GOOG.

Figure 4: The filter coefficients for the log-return data.

Now suppose we wish to extract a trading signal that performs like a trend signal during long sweeping upswings or downswings, and at the same time shares the property that it extracts smaller cyclical swings during a sideways or highly volatile period. This type of signal would be endowed with the advantage that we could engage in a long position during upswings, trade systematically during sideways and volatile times, and on the same token avoid aggressive long-winded downturns in the price. Financial trading can’t get more optimistic then that, right? Here is where the magic of the multi-bandpass comes in. I give my general “how-to” guidelines in the following paragraphs as a step-by-step approach. As a forewarning, these signals are not easy to build, but with some clever optimization and patience they can be done.

In this new formulation, I envision not only being able to extract a local bias embedded in the log-return data but also gain information on other important frequencies to trade on while in sideways markets. To do this, I set up the lowpass filter as I did earlier on $[0,\omega_0]$. The choice of $\omega_0$ is highly dependent on the data and should be located through a priori investigations (as I did above, without the additional bandpass).

Click on the Animation 2: Example of constructing a multiband pass using the Target Filter control panel in iMetrica. Initially, a low-pass filter is set, then the additional bandpass is added by clicking “Multi-Pass” checkbox. The location is then moved to the desired location using the scrollbars. The new filters are computed automaticall if “Auto” is checked on (lower left corner).

Before setting any parameterization regarding customization, regularization, or filter constraints, I perform a quick scan of the periodogram (averaged periodogram if in multivariate mode) to locate what I call principal trading frequencies in the data. In the averaged periodogram, these frequencies are located at the largest spectral peaks, with the most useful ones for our purposes of financial trading typically before $\pi/4$. The largest of these peaks will be defined from here on out as the principal spectral peak (PSP). Figure 6 shows an example of an averaged periodogram of the log-return for GOOG and AAPL with the PSP indicated. You might note that there exists a much larger spectral peak located at $7\pi/12$, but no need to worry about that one (unless you really enjoy transaction costs). I locate this PSP as a starting point for where I want my signal to trade.

Figure 5: Principal spectral peak in the log-return data of GOOG and AAPL.

In the next step, I place a bandpass of width around .15 so that the PSP is dead-centered in the bandpass. Fortunately with iMetrica, this is a seamlessly simple task with just the use of a scrollbar to slide the positioning of this bandpass (and also adjust  the lowpass) to where I desire. Animation 2 above (click on it to see the animation) shows this process of setting a multi-passband in the MDFA Target Filter control panel. Notice as I move the controls for the location of the bandpass, the filter is automatically recomputed and I can see the changes in the frequency response functions $\hat{\Gamma}$ instantaneously.

With the bandpass set along with the lowpass, we can now view how the in-sample performance is behaving at the initial configuration. Slightly tweaking the location of the bandpass might be necessary (width not so much, in my experience between .15 and .20 is sufficient).  The next step in this approach is now to not only adjust for the location of the bandpass while keeping the PSP located somewhat centered, but also adding the effects of regularization to the filter as well. With this additional bandpass, the filter has a tendency to succumb to overfitting if one is not careful enough.

In my first filter construction attempt, I placed my bandpass at $[.49,.65]$ with the PSP directly under it. I then optimized the regularization controls in-sample (a feature I haven’t discussed yet) and slightly tweaked the timeliness parameter (ended up setting it to 3) and my result (drumroll…)  is shown in Figure 6.

Figure 6: The trading performance and signal for the initial attempt at a building a multiband pass fitler.

Not bad for a first attempt. I was actually surprised at how few trades there were out-of-sample. Although there are no losses during the 80 days out-of-sample (after cyan line), and the signal is sort of what I had in mind a priori, the trades are minimal and not yielding any trading action during the period right after the large loss in Google when the market was going sideways and highly volatile. Notice that the trend signal gained from the lowpass filter indeed did its job by providing the local bias during the large upswing and then selling directly at the peak (first magenta dotted line after the cyan line).  There are small transactions (gains) directly after this point, but still not enough during the sideways market after the drop.  I needed to find a way to tweak the parameters and/or cutoff to include higher frequencies in the transactions.

In my second attempt, I kept the regularization parameters as they were but this time increased the bandpass to the interval $[.51, .68]$, with the PSP still underneath the bandpass, but now catching on to a few more higher frequencies then before.  I also slightly increased the length of the filter to see if that had any affect. After optimizing on the timeliness parameter $\lambda$ in-sample, I get a much improved signal. Figure 7 shows this second attempt.

Figure 7: The trading performance and signal for the second attempt at construction a multiband pass filter. This one included a few more higher frequencies.

Upon inspection, this signal behaves more consistently with what I had in mind. Notice that directly out-of-sample during the long upswing, the signal (barely) shows signs of the local bias, but enough not to make any trades fortunately. However, in this signal, we see that filter is much too late in detecting the huge loss posted by Google, and instead sells immediately after (still a profit however). Then during the volatile sideways market, we see more of what we were wishing for; timely trades to the earn the signal a quick 9 percent in the span of a couple weeks. Then the local bias kicks in again and we see not another trade posted during this short upswing, taking advantage of the local trend. This signal earned a near 22 percent ROI during the 80 day out-of-sample trading period, however not as good as the previous signal at  32 percent ROI.

Now my priority was to find another tweak that I could perform to change the trading structure even more. I’d like it to be even more sensitive to quick downturns, but at the same time keep intact the sideways trading from the signal in Figure 7. My immediate intuition was to turn on the i2 filter constraint and optimize the time-shift, similar to what I did in my previous article, part deux of the Frequency Effect. I also lessened the amount of smoothing from my weighting function $W(\omega; \alpha)$, turned off any amount of decay regularization that I had and voila, my final result in Figure 8.

Figure 8: Third attempt at building a multiband pass filter. Here, I turn on i2 filter constraint and optimize the time shift.

While the consistency with the in-sample performance to out-of-sample performance is somewhat less than my previous attempts, out-of-sample performs nearly exactly how I envisioned. There are only two small losses of less than 1 percent each, and the timeliness of choosing when to sell at the tip of the peak in the share price of Google couldn’t have been better. There is systematic trading governed by the added multiband pass filter during the sideways and slight upswing toward the end. Some of the trades are made later than what would be optimal (the green lines enter a long position, magenta sells and enters short position), but for the most part, they are quite consistent.  It’s also very quick in pinpointing its own erronous trades (namely no huge losses in-sample or out of sample). There you have it, a near monotonic performance out-of-sample with 39 percent ROI.

In examining the coefficients of this filter in Figure 9, we see characteristics of a trend filter as coefficients are largely weighting the middle lags much more than than initial or end lags (note that no decay regularization was added to this filter, only smoothness) . While at the same time however, the coefficients also weight the most recent log-return observations unlike the trend filter from Figure 4, in order to extract signals for the more volatile areas. The undulating patterns also assist in obtaining good performance in the cyclical regions.

Figure 9: The coefficients of the final filter depicting characteristics of both a trend and bandpass filter, as expected.

Finally, the frequency response functions of the concurrent filters show the effect of including the PSP in the bandpass (figure 10). Notice, the largest peak in the bandpass function is found directly at the frequency of the PSP, ahh the PSP. I need to study this frequency with more examples to get a more clear picture to what it means. In the meantime, this is the strategy that I would propose. If you have any questions about any of this, feel free to email me. Until next time, happy extracting!

Figure 10: The frequency response functions of the multi-bandpass filter.