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Oct 21, 2023

The Triple Barrier Method: A New Standard for Investment Labeling and Analysis

NUTHDANAI WANGPRATHAM Follow DataDrivenInvestor -- Listen Share Machine learning

NUTHDANAI WANGPRATHAM

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Machine learning (ML) has become increasingly popular in the investment industry as it offers powerful tools to analyze vast amounts of data and uncover patterns that may not be apparent to human analysts.

In most modern machine learning research, a form of classification known as the fixed-time horizon method is used. This method involves labelling the returns of our strategy at fixed-time intervals according to fixed thresholds to determine if a label should be "Buy" (if the returns exceed a certain threshold), "Sell" (if the returns dip below a certain threshold), or "Hold" (if the returns are somewhere between the two thresholds).

The main issue with using fixed-time horizon labeling for machine learning in investment is that it assumes that the investment horizon is fixed and known in advance. This approach involves labeling each observation as either positive or negative depending on whether the price movement over a fixed time period is above or below a certain threshold.

However, in reality, investment horizons are not fixed and known in advance, and market conditions can change rapidly. Moreover, using fixed-time horizon labeling ignores important information about the timing and magnitude of price movements.

The triple-barrier method addresses this issue by dynamically setting the labels based on the behavior of the price series itself. It takes into account both the timing and magnitude of price movements by setting a profit-taking barrier and a stop-loss barrier, and dynamically labeling each observation based on whether it hits one of these barriers before the end of the investment horizon.

In financial applications, a more realistic method is to make labels reflect the success or failure of a position. A typical trading rule adopted by portfolio managers is to hold a position until the first of three possible outcomes occurs: (1) the unrealized profit target is achieved, and the position is closed with success; (2) the unrealized loss limit is reached, and the position is closed with failure; (3) the position is held beyond a maximum number of bars, and the position is closed without neither failure nor success.

In short, we have three possible scenarios with two possible outcomes:

To use the Triple Barrier Method, a trader must first define the entry barrier, profit-taking barrier, and stop-loss barrier. These levels are typically determined based on technical analysis or other market indicators. Once these levels are defined, the trader can use them to label trades based on the hit sequence.

The hit sequence is a series of events that occur when the price of the underlying asset reaches one of the three barriers. When the price hits the entry barrier, the trade is labeled as "active." If the price then hits the profit-taking barrier before hitting the stop-loss barrier, the trade is labeled as "profitable." If the price hits the stop-loss barrier before hitting the profit-taking barrier, the trade is labeled as "unprofitable."

By using this dynamic labeling technique, the Triple Barrier Method provides a more accurate and flexible way to analyze trading opportunities. It takes into account the volatility of the market and provides a more robust framework for trading analysis.

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