What is 'Neural Network'

A neural network is a series of algorithms that endeavors to recognize underlying relationships in a set of data through a process that mimics the way the human brain operates. Neural networks can adapt to changing input so the network generates the best possible result without needing to redesign the output criteria. The conception of neural networks is swiftly gaining popularity in the area of trading system development.

BREAKING DOWN 'Neural Network'

Neural networks, in the world of finance, assist in the development of such process as time-series forecasting, algorithmic trading, securities classification, credit risk modeling and constructing proprietary indicators and price derivatives. A neural network works similarly to the human brain’s neural network. A “neuron” in a neural network is a mathematical function that collects and classifies information according to a specific architecture. The network bears a strong resemblance to statistical methods such as curve fitting and regression analysis.

A neural network contains layers of interconnected nodes. Each node is a perceptron and is similar to a multiple linear regression. The perceptron feeds the signal produced by a multiple linear regression into an activation function that may be nonlinear.

In a multi-layered perceptron (MLP), perceptrons are arranged in interconnected layers. The input layer collects input patterns. The output layer has classifications or output signals to which input patterns may map. For instance, the patterns may comprise a list of quantities for technical indicators about a security; potential outputs could be “buy,” “hold” or “sell.” Hidden layers fine-tune the input weightings until the neural network’s margin of error is minimal. It is hypothesized that hidden layers extrapolate salient features in the input data that have predictive power regarding the outputs. This describes feature extraction, which accomplishes a utility similar to statistical techniques such as principal component analysis.

Application of Neural Networks

Neural networks are broadly used, with applications for financial operations, enterprise planning, trading, business analytics and product maintenance. Neural networks have also gained widespread adoption in business applications such as forecasting and marketing research solutions, fraud detection and risk assessment.

A neural network evaluates price data and unearths opportunities for making trade decisions based on the data analysis. The networks can distinguish subtle nonlinear interdependencies and patterns other methods of technical analysis cannot. However, a 10 percent improvement in efficiency is all an investor can ask for from a neural network. There will always be data sets and task classes that a better analyzed by using previously developed algorithms. It is not so much the algorithm that matters; it is the well-prepared input data on the targeted indicator that ultimately determines the level of success of a neural network.

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