Is price random? The random walk hypothesis, the Philadelphia 76ers basketball team and our debt to Eugene Fama…

Nov 7 • Between the lines • 3202 Views • 1 Comment on Is price random? The random walk hypothesis, the Philadelphia 76ers basketball team and our debt to Eugene Fama…

flipping-coinIf we were to indulge in a sweeping generalization and select a group of people as being totally unsuited to retail trading, then those with a scientific background, or quantitative mathematics background, would probably come closest. These groups could be best described as refusing to accept that price is random. Many become fixated on finding order, where there is in fact chaos.

For those of a scientific background surrendering to probabilities versus absolutes can be an unsettling experience. They’ll look at a security on a chart and observe obvious patterns, many believing that these patterns and formulas will simply repeat themselves, time after time. And as many traders have found to their cost, as the markets dish out another serving of humble pie, no one can predict what price will do next with any degree of certainty.

Some of the finest minds in our industry, the quants who will devise various trading strategies working on the desks of major banks and institutions, know that price is unpredictable and (for the most part) random. Our best ‘guess’ is to look at the various patterns developing on a chart and (with a reasonable level of certainty) be able postulate that price will probably move one way as opposed to the other.

In the circa $6 trillion a day turnover market that is the FX industry it’s impossible to predict, with any form of accuracy, an unpredictable market. And yet many new traders become, similar to our traders from a scientific and mathematical background, obsessed with trying to find a 100% reliable trading method.

 

Taking a random walk to win a Nobel prize

Many traders will have missed the awards given out in October to various Nobel laureates and if they did see mention of the awards in the mainstream news, they’ll have probably failed to notice the relevance of one of the winning economic prize laureates to our every day trading activities and the paper he wrote way back in 1965.

In October 2013 the Royal Swedish Academy of Sciences awarded the 2013 Nobel to three American economists: Eugene Fama and Lars Peter Hansen at the University of Chicago and Robert Shiller of Yale University. The prizes were based on the importance of their work, which laid the foundation for the current understanding of asset prices and it’s Eugene Fama who we’re going to shine our own spotlight on.

Mr. Fama’s major contribution, notably with the 1965 paper; “Random Walks in Stock Market Prices,” illustrated that stock markets are very efficient. One implication of market efficiency is that trading rules, such as “buy when the price fell yesterday,” don’t actually work. Fama’s insight had profound effects for large and small investors. The suggestion being that it was a in fact a waste of time spending any money on professional financial managers actively trying to pick individual stocks as prices of stocks rapidly incorporate information that is publicly available.

 

The random walk hypothesis

The random walk hypothesis is a financial theory stating that stock market prices evolve according to a random walk and thus cannot be predicted. It is consistent with the efficient-market hypothesis that Eugene Fama put forward.

The concept can be traced to French broker Jules Regnault who published a book in 1863, and then to French mathematician Louis Bachelier whose Ph.D. dissertation titled “The Theory of Speculation” (1900) included some remarkable insights and commentary that are still as fresh today.

The same ideas were later developed by MIT Sloan School of Management professor Paul Cootner in his 1964 book The Random Character of Stock Market Prices. The term was popularized by the 1973 book, A Random Walk Down Wall Street, by Burton Malkiel, a Professor of Economics at Princeton University and was used earlier in Eugene Fama’s 1965 article “Random Walks In Stock Market Prices”, which was a less technical version of his Ph.D. thesis. The theory that stock prices move randomly was earlier proposed by Maurice Kendall in his 1953 paper, The Analytics of Economic Time Series, Part 1: Prices.

 

Heads or tails test

Burton G. Malkiel, an economics professor at Princeton University and writer of A Random Walk Down Wall Street, performed a test where his students were given a hypothetical stock that was initially worth fifty dollars. The closing stock price for each day was determined by a coin flip. If the result was heads, the price would close a half point higher, but if the result was tails, it would close a half point lower.

Therefore each time the price had a fifty-fifty chance of closing higher or lower than the previous day. Cycles or trends were determined from the tests. Malkiel then took the results in a chart and graph form to a chartist, a person who “seeks to predict future movements by seeking to interpret past patterns on the assumption that ‘history tends to repeat itself’”.

The chartist told Malkiel that they needed to immediately buy the stock. When Malkiel told him it was based purely on flipping a coin, the chartist was allegedly very unhappy. Malkiel argued that this indicated that the markets and stocks could be just as random as flipping a coin.

 

The Philadelphia 76ers

The random walk hypothesis was also applied to NBA basketball. Psychologists made a detailed study of every shot the Philadelphia 76ers made over one and a half seasons of basketball. The psychologists found no positive correlation between the previous shots and the outcomes of the shots afterwards. Economists and believers in the random walk hypothesis apply this to the stock market. The actual lack of correlation of past and present can be easily seen. If a stock goes up one day, no stock market participant can accurately predict that it will rise again the next. Just as a basketball player with the “hot hand” can miss the next shot, the stock that seems to be on the rise can fall at any time, making it completely random.

Share prices, many argue, adjust quickly to reflect new information, and new information cannot be predicted. Thus, trend analysis does not lead to improved long-term performance.

 

The Positive Feedback Trading Hypothesis (PFTH)

The Positive Feedback Trading Hypothesis (PFTH) provides a fascinating contrary theory to that of the random walk hypothesis, PFTH states that traders might look to buy a stock based on the simple observation that price is going up. These decisions are therefore rational, as opposed to a reaction to a random event; traders believe the existence of momentum as a reason for the stock price to rise higher. Hence, stock prices are chaotic, but not random. How much validity you should assign to PFTH depends on whether you think stock prices move in a chaotic manner or follow a random walk.

PFTH attempts to prove that price movement is driven by the actions of market participants. As a stock’s price begins to move in one direction, traders place orders to take advantage of the trend. As more traders buy (or sell) the stock, the upward (or downward) trend is extended. The trend then continues until new information emerges that warrants selling (or buying) the stock. Thus, price direction many would argue is chaotic, but not random.

However, the supporting evidence for the random walk theory is that trends can appear in patterns that are actually random. A coin can land on heads for several consecutive tosses. But despite this the odds of landing on heads remain a very steady 50%, regardless of how often the coin landed on heads for the previous 10 tosses. The chance of a roulette wheel ball landing on red or black is in no way tied to any of the previous spins; the odds stay at a steady 47%.

Random, chaotic, a “bit of both”? What is for sure that no one can predict with any certainty which way our markets will move. Perhaps the best we can achieve is a notation mentioned in the description we’ve proved of the PFTH theory. That buyers buy when price goes up and sell when price goes down. Discovering a method, to follow price for as long as the trend develops, really is as good as it gets.

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