If you are new to trading, you may wonder whether predicting financial markets is possible. You might also be wondering, can I really make money by predicting and trading the market?
At the University, you might hear that stocks move according to a random process, were making money – beating the market – is not a possibility.
In classical economic theory, financial trading is seen as something that is not much different from playing casino games or betting with a coin toss.
In other words, there is no way to generate consistent income from it.
If what the academics had thought until the 90s was true, we would not be traders, and we would not be different from people who waste their income in the lottery.
On the other hand, financial markets cannot be modeled as a deterministic process, in which no randomness is involved, and having all the data needed, making a 100% accurate forecast is certain.
In engineering, for example, with a group of differential equations, it is possible to model how the engine works or to find out how much fuel is needed to drive a car to a certain speed.
In the financial sector, we do not have this fortune, even if some naive questions, especially those new to finance, try hard to build a very complicated model that will predict the market. At some point, they will lower their expectations, grateful if they can find something that at least, ultimately, makes money.
If we are close to the conclusion that buying or selling shares does not belong to the deterministic or random world, then to what world is it located?
It’s time to talk about the complexity
A complex system is anything that consists of many elements that interact in an irregular way, from which a strong order is produced. There is no centralized control of how things behave.
Does this give you a warning? The element interacts in an irregular way, it seems like traders buy, sell, and influence each other, right? And maybe this crowd tends to behave all the time, following a kind of pattern, producing “strong orders?”
I am not the only one, of course, thinking that financial markets are a complex system – there are many papers on this topic. But they are difficult to understand if you are not familiar with this topic. I will try to make things simple and I will avoid using math and game theory.
By observing how investors behave, it is evident that the market fulfills most of the important characteristics of complex systems such as non-linearity, feedback, and spontaneous sequences.
In non-linear systems, changes in the input are not proportional to changes in output.
When the market looks quiet, some people buy and some sell, nothing strange so far. But if there are fewer sellers (bears) than buyers (bulls), they might not be able to push stock prices down. If they increase fivefold, the effect will be five times greater. But after several critical levels, the effect can change from linear to exponential and the stock may reach the lower limit. Transactions can then be deferred. This is clearly non-linear behavior.
The system participant receives feedback when the way his neighbors interact with him later depends on how he interacted with them at an earlier time. Each member of the flock takes a path that depends on the closeness and cushioning of the surrounding birds.
You must be sure that the complex characteristics of the financial markets are very important to show that traders do have the opportunity to make money.
What do Masters and scientists use when dealing with complex non-financial systems? Lots of mathematics of course, but also heuristics.
What do traders use when dealing with financial markets? Heuristics! They don’t even know that any form of technical analysis they use is heuristic!
Heuristics, very simple, run through trial and error – by rules, using practical methods, without guarantees of optimality or even rationality.