By Ishan Shah and Rekhit Pachanekar
Is it possible to predict where the Gold price is headed?
Yes, let’s use machine learning regression techniques to predict the price of one of the most important precious metal, the Gold.
We will create a machine learning linear regression model that takes information from the past Gold ETF (GLD) prices and returns a Gold price prediction the next day.
GLD is the largest ETF to invest directly in physical gold. (Source)
We will cover the following topics in our journey to predict gold prices using machine learning in python.
- Import the libraries and read the Gold ETF data
- Define explanatory variables
- Define dependent variable
- Split the data into train and test dataset
- Create a linear regression model
- Predict the Gold ETF prices
- Plotting cumulative returns
- How to use this model to predict daily moves?
Import the libraries and read the Gold ETF data
First things first: import all the necessary libraries which are required to implement this strategy.
Then, we read the past 12 years of daily Gold ETF price data and store it in Df. We remove the columns which are not relevant and drop NaN values using dropna() function. Then, we plot the Gold ETF close price.
Output:
Define explanatory variables
An explanatory variable is a variable that is manipulated to determine the value of the Gold ETF price the next day. Simply, they are the features which we want to use to predict the Gold ETF price.
The explanatory variables in this strategy are the moving average for past 3 days and 9 days. We drop the NaN values using dropna() function and store the feature variables in X.
However, you can add more variables to X which you think are useful to predict the prices of the Gold ETF. These variables can be technical indicators, the price of another ETF such as Gold miners ETF (GDX) or Oil ETF (USO), or US economic data.
Define dependent variable
Similarly, the dependent variable depends on the values of the explanatory variables. Simply put, it is the Gold ETF price which we are trying to predict. We store the Gold ETF price in y.
Split the data into train and test dataset
In this step, we split the predictors and output data into train and test data. The training data is used to create the linear regression model, by pairing the input with expected output.
The test data is used to estimate how well the model has been trained.
- First 80% of the data is used for training and remaining data for testing
- X_train & y_train are training dataset
- X_test & y_test are test dataset
Create a linear regression model
We will now create a linear regression model. But, what is linear regression?
If we try to capture a mathematical relationship between ‘x’ and ‘y’ variables that “best” explains the observed values of ‘y’ in terms of observed values of ‘x’ by fitting a line through a scatter plots then such an equation between x and y is called linear regression analysis.
To break it down further, regression explains the variation in a dependent variable in terms of independent variables. The dependent variable - ‘y’ is the variable that you want to predict. The independent variables - ‘x’ are the explanatory variables that you use to predict the dependent variable. The following regression equation describes that relation:
Y = m1 * X1 + m2 * X2 + C Gold ETF price = m1 * 3 days moving average + m2 * 15 days moving average + c
Then we use the fit method to fit the independent and dependent variables (x’s and y’s) to generate coefficient and constant for regression.
Output:
Linear Regression model
Gold ETF Price (y) = 1.20 * 3 Days Moving Average (x1) + -0.21 * 9 Days Moving Average (x2) + 0.43 (constant)
Predict the Gold ETF prices
Now, it’s time to check if the model works in the test dataset. We predict the Gold ETF prices using the linear model created using the train dataset. The predict method finds the Gold ETF price (y) for the given explanatory variable X.
Output:
The graph shows the predicted and actual price of the Gold ETF.
Now, let’s compute the goodness of the fit using the score() function.
Output:
99.21
As it can be seen, the R-squared of the model is 99.21%. R-squared is always between 0 and 100%. A score close to 100% indicates that the model explains the Gold ETF prices well.
Plotting cumulative returns
Let’s calculate the cumulative returns of this strategy to analyse its performance.
- The steps to calculate the cumulative returns are as follows:
- Generate daily percentage change of gold price
- Create a buy trading signal represented by “1” when the next day’s predicted price is more than the current day predicted price. No position is taken otherwise
- Calculate the strategy returns by multiplying the daily percentage change with the trading signal.
- Finally, we will plot the cumulative returns graph
The output is given below:
We will also calculate the Sharpe ratio.
The output is given below:
'Sharpe Ratio 1.06'
Suggested Reads:
- Top 10 machine learning algorithms which can be used in your trading strategy
- Learn all about Exchange-Traded Funds (ETF)
How to use this model to predict daily moves?
You can use the following code to predict the gold prices and give a trading signal whether we should buy GLD or take no position.
The output is as shown below
Congrats! You just learned a fundamental yet strong machine learning technique, with an example of Gold price prediction. Thanks for reading!
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Access the Github link below: Gold Price Prediction Strategy Jupyter Notebook
Disclaimer: All investments and trading in the stock market involve risk. Any decisions to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.
