Chaos theory applied to trading
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To recall what exactly trading is, it is a long battle between buyers and sellers: each of these traders will have a more or less significant impact on prices and these prices, moreover, reflect the general psychological state of investors at an instant T. From the moment this battle has a direct impact on prices, we can say that trading always keeps a small place at random, and this chance is actually governed by rules: this is the theory of chaos.
I] THEORY OF CHAOS IN TRADING
A) EXPLANATION OF THEORY
The theory of chaos studies the behavior of dynamic systems that are very sensitive to initial conditions, which is a phenomenon generally illustrated by the butterfly effect. Surely you remember a movie with the same name? This is normal, because it is exactly this effect that is part of the chaos theory. In the film, a man loses his wife and has the power to return to the past to change events. Only, each time, he modifies a slight detail that will change the whole course of his life, and in a totally different way than he had planned.
The theory of chaos is a bit like that: in a sequence that repeats itself, it suffices to slightly change a parameter to have completely different results and mathematical effects.
B) THEORY IN THE LIFE OF EVERY DAY
If not many people know this theory, know that it is applicable to the base of many natural systems such as weather or climate. These phenomena have been studied by chaotic mathematical models, by their chaotic nature.
Otherwise, this system is also applied in many other ways such as sociology, physics, computer science, engineering, biology, philosophy and finally, a sector that interests us: the economy and finance of market.
C) THEORY OF CHAOS AND TRADING
In trading, the theory of chaos is omnipresent. Indeed, there is very little tracing and the movement of past prices will not necessarily give the same price movements future. Graphical figures last only a short time and elements such as breakouts or returns in the graphic figure are totally unpredictable over time. We can determine the price zone or zones where a potential reaction can take place, but we will never know exactly what will happen in these zones, because it is enough for a parameter to be changed to obtain a final result totally. outside of the initial expectations.
II] TRADING SYSTEMS WITH FIXED VARIABLES
A) INSURED FAILURE
Have you not noticed, especially in robotized or automatic trading systems, that after a certain time, the performance of the robot is reduced or even the opposite of what it was supposed to produce as profits ?
This is normal, because the market has kept some unpredictable part in its structure and this unpredictable side is created by the sum of human psychologies that are inherently totally unpredictable.
In the case of robotic trading systems whose parameters are defined by fixed variables in a random variable market, it is more than obvious that this system will, in a more or less long period of time, have performance gaps. compared to what it is expected to make profit. To schematize, we will take two superimposed graphs: we imagine that the robot starts to trade the market well, with a performance of 1% per day, and that the market shifts its variables so as to create a differential of 0.05% per day. In other words, every day that passes, the robot produces a margin of error that widens by 0.05% per day.
Well, we can see that the real results are totally unpredictable with fixed variables and that the more the time passes, the more the robot makes random performances. This is due to two important market factors: the delta, which measures the difference in performance between two systems, and the theta, which is the measure of the influence of time on the strategy. So it should be noted that: Fixed variable system = delta dependence and theta = random results = failure for sure.
III] VARIABLE TRADING SYSTEMS
A) WHY ARE ALL ALSO VULNERABLE?
Theoretically, self-regulating trading systems are a bit more likely to last, even if they are doomed to fail in the long run. In fact, the margin of error that applied to performance in fixed-variable strategies is no longer on performance, but on the non-fixed variable. This offset on the variable will have an effect on the result (butterfly effect). The same graph will be obtained as in II.A. Simply because this margin of error will increase on the variable part of the strategy that this one will be carried forward indirectly on the result. It's crazy, is not it?
B) CHAOTIC-BASED SYSTEMS
Think again, using a chaotic math-based strategy will have the same effects as with any other automatic strategy. Simply because we do not fight chaos with chaos. Chaos is inherently unpredictable, but beware, in an unpredictable system, only probabilities and probability calculations can generate a positive result in the long run. And that's why trading systems need to be constantly changed.