“It is remarkable that a science which began with the consideration of games of chance
should become the most important object of human knowledge … the most important
questions of life are for the most part only problems of probability.”
Pierre Simon De La Place
Theorie Analystique Des Probabilities 1812
Take a coin and toss it into the air. As the coin spins in the air you have no idea and
cannot predict which way it is going to fall. Yet over many tosses the outcome can
reasonably be predicted. Just as we can predict the tosses of a coin with probability, so
too can we use probabilities to predict market direction. When you trade you need to
trade with the probabilities and odds in your favour.
In recent years many academics have scoffed at the idea that markets can be predicted
and they point to the theory of Random Walk. The theory is based on the assumption
that markets are efficient. The market is one where a large number of equally well
informed people actively compete to try and maximise profits. In such a market, at any
time, the price will re ect all available information as well as all events expected to occur
in the foreseeable future. The theory holds that as all current and future events are
discounted, the individual’s chances of over performing or under performing the market
as a whole are even, i.e. you can never put the odds in your favour, and therefore will
not be able to earn consistent profits. If the theory is correct, our rules and all our
trading efforts will count for nothing.
It is amazing this theory has become so widespread and so many people believe it. It is,
however, completely incorrect as it assumes that the decision-making process conforms
to scientific theory. It quite clearly does not; the facts are there for all to see. However,
we all make personal subjective judgements based upon our knowledge, understanding
and emotions. Given the same information, we do not all reach the same conclusions.
If we discount the Random Walk theory and say that human behaviour is unpredictable,
then how can we put the odds in our favour? The answer lies in probabilities discussed
earlier. To trade the markets you need to trade to minimise risk, and maximise gains.
The way to do this is to catch the trend. Take any chart over a period of time and you
will notice trends and recurring patterns. If all humans think differently, how and why
do these patterns emerge?
The answer can be found in the theory of “chaos”, which postulates that certain types
of natural activity are chaotic except in terms of probability. To give an example, the
heartbeat of a person can be charted but given certain conditions, a heart will go into
random fibrillation during which time the heartbeat cannot be predicted or modelled.
Mathematically, weather forecasting is another area where chaos theory applies. The
unpredictability of weather forecasting comes from what is called sensitivity to initial
conditions. Mathematical models fail in forecasting because the slightest divergence
between simulated and actual conditions multiplies in a complex chain of cause and
effect relationships, giving rise to results in the model totally different than in nature.
The best meteorologists can do is to forecast weather within the limits of probability.
While admitting that certain events in nature don’t follow a perfect mathematical order,
chaos theory says that they can still be understood, predicted and controlled. It directly
challenges Random Walk that there is no way of predicting market movement. There
are no certain predictions but there is order to the chaos, and forecasts can be made on
the basis of probability. To understand probability in financial markets, we need to look
at the psychology of the participants.
Why chaos theory is so important.
“The organisation of the Universe demands that matters abandon itself to the games of
chance.”
H. Reeves - Atoms of Science
The theory of chaos is not a theory to help you make investment decisions, its usefulness
lies in the greater understanding it gives us of the trading environment and how we
should cope with it.
1. It shows us how human psychology in uences price movement, why trends occur,
and how they can end up being understood in terms of probability. The herd mentality
is fully explained in our Special Situations Report available from the office. Human
psychology has remained constant over time, and it is this fact that helps us predict the
probability of price movement via technical analysis.
2. It disproves Random Walk theory; although market movements may appear
random, under statistical tests they are not.
3. If it disproves that the markets are random, it also shows why the quest for the
“Holy Grail” computerised or mechanical trading system is doomed to failure. It also
confronts those disciples of such analysts as Gann and Elliott who believe the Universe
is ruled by law.
4. It helps us to operate in an unstructured environment by giving us a greater
understanding of it. The best you can do is understand the original conditions that give
rise to probable future events, and act accordingly. This may sound disheartening, it is
not. By understanding chaos, you will be able to keep the odds firmly in your favour. If
you can do that, you will end up making a lot of money from your trading, year in year
out.
