Chaos, Stock Markets, and the repetitive patterns
The Stock Market is a blooming, buzzing system of confusion, a mess of quirky patterns, but only to the untrained eye. The patterns in the markets are never quite regular, and never seem to repeat exactly. The idea is that all this mayhem, all this chaos, is underpinned, indeed determined, by mathematical rules and that we can work out what those rules might be, counter to our most dearly held perceptions.
What I am going to talk about here, today is that there is a strange and unexpected relationship between order and chaos, that there is a method in the madness that we see in the stock markets.
The BIG Idea
Think of the way a steady wind flowing across sand creates all kinds of shapes. The sand grains self-organize into ripples, waves, and dunes. A pattern emerges. This happens even though the grains are virtually identical and have no knowledge of the shape they become part of. In a very similar way, the random movements in the markets self-organize into different patterns. Self-organization seems to operate all over the natural world, and so it does in the stock markets as well. Find the mathematics that describes the system, and you can then predict how the system will unfold. That is the big idea. The more careful your measurements are today, the better are your prospects of predicting what will happen tomorrow.
The Chaos Theory and The Stock Market
The discovery of the phenomenon known as chaos changed the way scientists looked at self-organization. ‘Chaos’ has a very specific meaning in science. It says that a system that is completely described by mathematical equations is more than capable of being unpredictable without any outside interference. There’s a widespread misapprehension that chaos is just somehow saying the very fact that everything’s complicated.
Some very, very simple rules or equations with nothing random in them can have outcomes that are entirely unpredictable. In essence, under the given circumstances, the tiniest difference in the starting positions of a system, differences that are too small to measure, can get bigger and bigger which each moment that passes as the system runs. With each step in the process, the system then moves further and further away from where you thought it was going. The same happens in the stock markets. Every stock has a different starting point, a different demand, and supply equation and thus each stock follows its own pattern which may be different than every other stock at any given moment. But there are common underlying patterns in the market, which if detected, can be used to detect the trend of a stock, or the market overall, in the future.
The truth of the underlying patterns in chaos seem like an illusion to most of us. Unpredictability is hardwired into every aspect of the world we live in. The global climate can change in a few years; the stock market could crash without a warning! We could be wiped from the face of the planet overnight and there’s nothing anyone can do about it. So, to be scared of chaos is pointless as its woven into the basic laws of physics. We have to accept it as a fact of life.
The Stock Markets are deeply, profoundly unpredictable. But the very same things that make it unpredictable also allow it to create pattern and structure, order and chaos. The two are deeply linked than one can ever imagine. Though both order and chaos behave in very complicated ways, they are both based on surprisingly simple mathematical rules. These rules have a unique property. A property that is often referred to as coupling or feedback. The same system, one that’s based on simple rules with feedback, produces chaos and order. The same mathematics generates chaotic behavior and patterned behavior. These are two ends of the spectrum of behavior which can be generated by the same kind of mathematics. From the discoveries in chemistry and biology one can take home the fact that, ultimately, pattern formation seems to be woven very, very deeply into the fabric of the universe and hence, into the Stock Markets as well. Patterns are everywhere; it’s just waiting to happen. Chaos and pattern are built into nature’s most basic rules. Underlying nearly all the shapes in the world is a mathematical principle known as self-similarity. This describes anything in which the same shape is repeated over and over again at smaller and smaller scales. A great example is the branches of trees. They fork and fork again repeating that simple process over and over at smaller and smaller scales. The same branching principles apply in the structure of our lungs and the way our blood vessels are distributed throughout our body. It even explains how a river splits into ever smaller streams. Such geometry, with its basis in self-similarity, is known as fractal (discovered by Mandelbrot). What if one can represent this property of nature in mathematics? What if we can capture the essence to draw a pattern and predict the future outcome? Could you use a simple set of mathematical rules to find patterns in the stock markets which look entirely random to human eyes? Yes, we can.
Complex systems can be based on simple rules
The answer to this problem of finding a pattern in complex systems is evolution, which is a process that engineers these unpredictable complex systems. The way evolution refines and enriches complex systems, using simple mathematical rules, is one of the most intriguing ideas that can be used in detecting patterns and predicting Stock Market trends, using technologies like AI. Evolution in the algorithm for the stock markets will itself be based on simple rules and feedback. Think about it. Once you detect stocks that actually have patterns on them, these can be selected against by processes and can be used for trading. The mathematics of pattern formation shows that some kind of pattern can show up in an enormous range of different systems. Somewhere deep down inside common patterns emerge in every system. So what is the ultimate lesson we can take from all this? Well, it’s that all the complexities of the stock markets emerge from mindless, simple, predictable patterns, repeated over and over again.
That’s the essence of this blog.
Some ‘Long Term’ patterns in the ‘Chaotic’ Markets, across the world
There are various patterns that keep repeating over a period of time in the markets. We will be discussing each one of them in the blogs to come.