HOW THE MARKETS REALLY WORK

“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 toprobabilities 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
reflect 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.sses of a coin with probability, so too can we use.