Forex Articles - Forex Chaos Theory

Are We Being Fooled By The Randomness Of Forex Markets When Chaos Theory Exists?

Nov 21 • Forex Trading Articles • 5935 Views • 4 Comments on Are We Being Fooled By The Randomness Of Forex Markets When Chaos Theory Exists?

As forex traders we're self conditioned to make trading decisions and ultimately take our forex trades based on two key principles, fundamental and technical analysis. The first principle, fundamental analysis, is (on the face of it) straightforward. FA requires very little depth of thought after a brief period of experience; if the news gets any worse with regards to the Eurozone crisis we can expect the euro to fall versus what are then considered 'safe-haven' currencies such as: yen, dollar, Swissy and the Loonie. The information delivered by way of policy announcement or data releases eventually finds its way onto our charts. Due to the state of the art platforms and charting packages we put faith in, in order to ply our trade, this 'information bleed' is incredibly quick. The human interaction and the sentiment regarding a currency vis a vis another currency is instantly displayed. However, the news release impact can often front run the bid and offer on our platforms.

Many of us upon discovering FX trading can be swayed by forceful opinions, especially if these opinions gather moss as they roll down the hill unchallenged eventually becoming deeply buried in a forest of folklore. One such opinion is that "indicators don't work" a claim often repeated on trading forums. Whilst it's fun to engage in put downs, citing the commendations of the brilliant mathematical minds who've created the indicators, to then politely ask what qualifications the forum member has to challenge such expertise, it may be more appropriate to ask for 'proof' that indicators don't work. Nassim Taleb once stated that his major hobby is;

Teasing people who take themselves and the quality of their knowledge too seriously and those who don’t have the guts to sometimes say: ‘I don’t know..

Let's consider Nassim Taleb, Henri Poincaré, randomness, probability, Edward Lorenz and his butterfly effect and how they relate to trading. Of particular note is one incredibly prophetic quote from Taleb when he asserts that option pricing is determined in a "heuristic way" by operators, not by a model, and that models are "lecturing birds on how to fly".

I've provided some information in this article on both Taleb and chaos theory, as you read it'll become quite obvious the links between the two subjects and how they directly relate back to trading, particularly when exploring and analysing the use and validity of the various models we place so much trust in. Hopefully this sparks some interest and leads readers into a new and expansive area of knowledge. It may not affect our fundamental decision, that's not the objective. However, testing our own core trading beliefs, particularly 'ingredients' so core to our potential success as fundamental and technical analysis, can be an incredibly worthwhile exercise.

Nassim Taleb
Nassim Taleb is a Lebanese American who focuses on problems of randomness and probability. His 2007 book The Black Swan was described in a review by Sunday Times as one of the twelve most influential books since World War II. He's a bestselling author and has been a professor at several universities, currently at the Polytechnic Institute of New York University and Oxford University. He's a practitioner of mathematical finance. Taleb has been a hedge fund manager, a Wall Street trader and currently a scientific adviser at Universa Investments and the International Monetary Fund.

He criticised the risk management methods used by the finance industry and warned about financial crises. He advocates what he calls a "black swan robust" society, meaning a society that can withstand difficult-to-predict events. He favours "stochastic tinkering" as a method of scientific discovery, by which he means experimentation and fact-collecting instead of top-down directed research.

He calls for cancellation of the Nobel Memorial Prize in Economics, saying that the damage from economic theories can be devastating. He opposes top-down knowledge as an academic illusion and believes that price formation obeys an organic process. Together with Espen Gaarder Haug, Taleb asserts that option pricing is determined in a "heuristic way" by operators, not by a model, and that models are "lecturing birds on how to fly". Pablo Triana has explored this topic with reference to Haug and Taleb and says that perhaps Taleb is correct to urge that banks be treated as utilities forbidden to take potentially lethal risks, while hedge funds and other unregulated entities should be able to do what they want.

Fooled by Randomness
Taleb's first non-technical book, Fooled by Randomness, about the underestimation of the role of randomness in life, was published in 2001. The book was selected by Fortune as one of the 75 "Smartest Books of All Time." The book's name, Fooled by Randomness, has also become an idiom in English used to describe when someone sees a pattern where there is just random noise.

Taleb sets forth the idea that modern humans are often unaware of the existence of randomness. They tend to explain random outcomes as non-random. Human beings:
overestimate causality, e.g., they see elephants in the clouds instead of understanding that they are in fact randomly shaped clouds that appear to our eyes as elephants (or something else); tend to view the world as more explainable than it really is. So they look for explanations even when there are none.

Other misperceptions of randomness that are discussed include: Survivorship bias. We see the winners and try to "learn" from them, while forgetting the huge number of losers.

Skewed distributions. Many real life phenomena are not 50:50 bets like tossing a coin, but have various unusual and counter-intuitive distributions. An example of this is a 99:1 bet in which you almost always win, but when you lose, you lose all your savings. People can easily be fooled by statements like "I won this bet 50 times". According to Taleb: "Option sellers, it is said, eat like chickens and go to the bathroom like elephants", which is to say, option sellers may earn a steady small income from selling the options, but when a disaster happens they lose a fortune.

His second non-technical book, The Black Swan, about unpredictable events, was published in 2007. It sold, as of February 2011, close to 3 million copies and spent 17 weeks on the New York Times Bestseller list and was translated into 31 languages. The Black Swan has been credited with predicting the banking and economic crisis of 2008.

Taleb's non-technical writing style mixes a narrative style (often semi-autobiographical) and short philosophical tales together with historical and scientific commentary. The sales of Taleb's first two books garnered an advance of $4 million for a follow-up book on anti-fragility.

Chaos Theory
Chaos theory is the study of nonlinear dynamics, where seemingly random events are actually predictable from simple deterministic equations. In a scientific context, the word chaos has a slightly different meaning than it does in its general usage as a state of confusion, lacking any order. Chaos, with reference to chaos theory, refers to an apparent lack of order in a system that nevertheless obeys particular laws or rules; this understanding of chaos is synonymous with dynamical instability, a condition discovered by the physicist Henri Poincare in the early 20th century that refers to an inherent lack of predictability in some physical systems.

 

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Henri Poincaré
Henri Poincaré was a mathematician and physicist, he made many original fundamental contributions to pure and applied mathematics, mathematical physics, and celestial mechanics. He was responsible for formulating the Poincaré conjecture, one of the most famous problems in mathematics. In his research on the three-body problem, Poincaré became the first person to discover a chaotic deterministic system which laid the foundations of modern chaos theory. He is also considered to be one of the founders of the field of topology.

The two main components of chaos theory are the ideas that systems, no matter how complex they may be, rely upon an underlying order, and that very simple or small systems and events can cause very complex behaviours or events. This latter idea is known as sensitive dependence on initial conditions, a circumstance discovered by Edward Lorenz (who is generally credited as the first experimenter in the area of chaos) in the early 1960s.

Edward Lorenz
Lorenz, a meteorologist, was running computerised equations to theoretically model and predict weather conditions. Having run a particular sequence, he decided to replicate it. Lorenz reentered the number from his printout, taken half-way through the sequence, and left it to run. What he found upon his return was, contrary to his expectations, these results were radically different from his first outcomes. Lorenz had, in fact, entered not precisely the same number, .506127, but the rounded figure of .506. According to all scientific expectations at that time, the resulting sequence should have differed only very slightly from the original trial, because measurement to three decimal places was considered to be fairly precise. Because the two figures were considered to be almost the same, the results should have likewise been similar.

Since repeated experimentation proved otherwise, Lorenz concluded that the slightest difference in initial conditions beyond human ability to measure made prediction of past or future outcomes impossible, an idea that violated the basic conventions of physics. As the famed physicist Richard Feynman pointed out, "Physicists like to think that all you have to do is say, these are the conditions, now what happens next?"

Newtonian laws of physics are completely deterministic: they assume that, at least theoretically, precise measurements are possible, and that more precise measurement of any condition will yield more precise predictions about past or future conditions. The assumption was that, in theory, at least, it was possible to make nearly perfect predictions about the behaviour of any physical system if measurements could be made precise enough, and that the more accurate the initial measurements were, the more precise would be the resulting predictions.

Poincare discovered that in some astronomical systems (generally consisting of three or more interacting bodies), even very tiny errors in initial measurements would yield enormous unpredictability, far out of proportion with what would be expected mathematically. Two or more identical sets of initial condition measurements, which according to Newtonian physics would yield identical results, in fact, most often led to vastly different outcomes. Poincare proved mathematically that, even if the initial measurements could be made a million times more precise, that the uncertainty of prediction for outcomes did not shrink along with the inaccuracy of measurement, but remained huge. Unless initial measurements could be absolutely defined – an impossibility – predictability for complex – chaotic – systems performed scarcely better than if the predictions had been randomly selected from possible outcomes.

The Butterfly Effect
The butterfly effect, first described by Lorenz at the December 1972 meeting of the American Association for the Advancement of Science in Washington, D.C., vividly illustrates the essential idea of chaos theory. In a 1963 paper for the New York Academy of Sciences, Lorenz had quoted an unnamed meteorologist's assertion that, if chaos theory were true, a single flap of a single seagull's wings would be enough to change the course of all future weather systems on the earth.

By the time of the 1972 meeting, he had examined and refined that idea for his talk, "Predictability: Does the Flap of a Butterfly's Wings in Brazil set off a Tornado in Texas?" The example of such a small system as a butterfly being responsible for creating such a large and distant system as a tornado in Texas illustrates the impossibility of making predictions for complex systems; despite the fact that these are determined by underlying conditions, precisely what those conditions are can never be sufficiently articulated to allow long-range predictions.

Although chaos is often thought to refer to randomness and lack of order, it is more accurate to think of it as an apparent randomness that results from complex systems and interactions among systems. According to James Gleick, author of "Chaos : Making a New Science", chaos theory is;

A revolution not of technology, like the laser revolution or the computer revolution, but a revolution of ideas. This revolution began with a set of ideas having to do with disorder in nature: from turbulence in fluids, to the erratic flows of epidemics, to the arrhythmic writhing of a human heart in the moments before death. It has continued with an even broader set of ideas that might be better classified under the rubric of complexity.

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