Stock Market Chaos Theory

Patterns for Profits Newsletter - July 4, 2008

Chaos theory is not about chaos but about the patterns that are hidden in and govern “non-linear” and “dynamic” systems. Beside the weather, the stock market is a non linear dynamic system. What appears to be random is governed by rules and can be understood, and predicted, in pieces. Learn some of the pieces, the “fractals,” to use the scientific term, and make money in the market.

The Long and the (Very) Short Term

Buy and hold investors will say that the way to make money in the market is to believe in the gradual appreciation of well run companies. The problem here is that when you look at the appreciation in value of a great stock over several years that amount of appreciation is dwarfed by the end of day ups and downs in stock price throughout that period. That amount in turn is dwarfed by the ups and downs in stock price seen trading day after trading day.

Smart traders know this. That is why they look for patterns in the market, indications of group psychology, breaking news and the reaction to it, and pure technical factors indicating market “sentiment.”

Stock Market "Chaos" and Patterns for Profit

The stock market, the currency exchanges, any reasonable transparent, fairly run system usually appears to have a built in randomness. This is the chaos of a “non linear” and “dynamic” system. That is, the market does not move in a straight line but keeps jumping up and down with buys and sells. The whole system is always in flux, or dynamic.

In studying so called chaotic systems, researchers have come up with the term “fractal” which is a characteristic of the system that is seen throughout all parts of the system (read market here). The study of chaos theory is very complex in the province of mathematicians. However, we are not especially interested in describing all characteristics of the market, weather, molecular vibrations, etc. We are interested in applying a “fractal” or two to stock market trading; we are interested in patterns for profits.

Market Psychology

Let’s say that the economic news is bad and that investors are jittery. The options market is active with traders placing their bets, so to speak, on where the market will jump to next. The long term investor will buy or sell stocks or options based upon his or her expectation of market movement over the next months or years. The trader will have developed a system for reading market trends, micro trends, and will be able to take repeated profits with each jump and correction as the market moves to its next state of temporary equilibrium.

The pros will tell you that the profit is in the patterns. The chaos folks would say that it’s all in the fractals. I like to think of patterns, even micro patterns, because when I think of fractals I see snowflakes (same repeating pattern at small and large scale). On the other hand maybe a vision of the dynamic market as snowflakes is not so bad. The patterns keep repeating on smaller or larger scales. Every time the market is in flux, the same predictable patterns of human psychology apply, not to mention the reasonably predictable responses (psychological) by regulatory agencies, news media, etc.

Regulatory Response

Whatever the direction of the market, whatever the news, we always watch what the Federal Reserve is going to do with interest rates. Whatever they do each month, the psychology is very similar every month. Everyone “places their bets” or “hedges their bets” in a patterned manner. Chaos theory shows that it is difficult if not impossible to predict individual behavior of a part of a system and that the entire system may seem to act randomly. But the behavior or parts of the system may be predictable. Even the supposedly independent market regulators are part of the complex of overlapping patterns that make the market.

So Where Does that Leave Us?

I hope all this talk of chaos and fractals has not put you off. The point is that there is scientific justification for looking for, recognizing, and exploiting patterns in any market system. Now, I am talking about a reasonably fair and well governed market. If the market is rigged by insiders, that is a BIG “fractal” that’s hard to beat. Discipline is key. Develop a system, test a system, use a system, and revise a system but let the system do its job. Every time you take a detour from a developed system of exploiting market patterns you become part of the herd mentality, the group psychology. You might as well wear a T-shirt with FRACTAL stenciled on it. Use your patterns for profits and work the system instead of letting it work you.

Traders were looking for patterns and exploiting them long before “chaos” theory was described. Some things can be understood intuitively before the mathematicians arrive. And, once the experts move on to different hot research topics, smart traders will still be searching out stock market patterns for profits.

Patterns For Profits Market Review

The Dow Index has now made lows on the year. If you have been following the newsletter the last few months or are a member in our live trading room and website you would have seen numerous charts posted showing the January 2008 lows to watch. The Dow Index also retested the breakout area from the daily head and shoulder pattern and this is where that index turned down from.

The SP 500 rallied up to 1441 and has had a steep decline to lows of 1272.75, which is also the .886 support, as of this writing. See chart below.

With such a strong move down, the market should find resistance on any rallies up and we will be looking for intraday sell patterns.

Should the SP 500 exceed the January 2008 lows this could bring in more selling and we could see deeper retracements based on the longer term weekly charts.

Patterns for Profits Trading Tips - Uncertainty in the Markets

This month’s Trading Tips is an article from Michael S. Shropshire, Ph.D of MarketWise.com.

Accept Uncertainty and Move On

When trading the markets, uncertainty is often a fact of life. But many traders don't like the idea of putting their money on the line when there is a good chance they will lose it. They seek out certainty, and precision. Last weekend at Trader's Expo in southern California, I saw the need for certainty and perfection at work firsthand. Software vendors promised that their software could help traders identify winning patterns with ease. It was tempting to believe that all one needs to make huge wins is the right software package. When it came to technical analysis classes, I saw trading gurus make reading the price action as simple as looking at the daily price range. But trading is not precise and it’s not that easy. It is not an exact science. Unfortunately, history only repeats itself when it does. And a pattern may unfold according to conventional wisdom under some market conditions but not under others.

It is understandable why traders seek out certainty. If the markets followed regular patterns and you could see them easily, winning would almost be assured. Many traders seek out a level of consistency in the financial markets that just does not exist, however. They believe that the markets follow natural laws and falsely believe that there are some magical mathematical principles that underlie it all. Big time institutional investors may be able to forecast the market action in the long term, but they have mountains of capital and can attempt to hedge risk, and even they have great difficulty merely matching the yearly increases of the indexes. For the smaller investor or trader, there are no secret mathematical formulae. The past is the past, and what happened in the past may not forecast the future.

Don't falsely think that you can forecast market action with the same precision a physicist can program a satellite to orbit Mars. The markets don't follow natural laws. There are many unknown factors that underlie the price action. The best you can do is study all available information and make an educated guess. As long as you manage risk, you can make trade after trade and get the odds to work in your favor. You won't be right all the time, but you'll be right enough of the time to make a profit. It may be pleasing to think that you can add certainty to trading, but you can't. You'll feel better in the long run and trade more profitably if you accept the fact that the future is uncertain.

The Problem

Traders seek out a level of certainty when trading the markets that just does not exist. It is vital to accept that the markets are uncertain.

Mental Edge Strategies

The kind of people who do well as traders are passionate about success. They believe in taking charge of their lives and doing whatever it takes to achieve success. Although taking control of one's destiny is vital for success, there is a downside. There are times when we just can't take control entirely. We must accept that life can be uncertain, and regardless of how hard we try, we just can't control every aspect of our destinies.

Life can often be uncertain. We don't want to believe that we can be helpless and powerless at times. Indeed, mentally healthy people tend to have a biased view when estimating how much control they actually have over their destinies. They believe that they can control anything that comes their way. But as hard as it is to accept, we just can't control everything. The challenge is to identify what we can control and what we cannot. It is vital for survival to know what we can control and devote our efforts to controlling these events, but at the same time, it is essential to avoid wasting time on trying to control events that we just can't do anything about. When it comes to trading, there is a lot we can do to control our destiny. Rather than trade haphazardly, we can delineate a detailed trading plan and follow it. We can manage risk to insure that we can survive a few losing trades and allow us to feel assured that we can recover should we face a severe drawdown. We can also try to anticipate adverse events, such as earnings reports, that may go against our trade. But no matter how hard we try, we can't account for every possible event. For example, there may be unexpected news about national events that is impossible to anticipate. The best one can do is control risk on a trade to prepare for such a possibility. But worrying about such an event happening, or thinking we can account for every possibility will use up psychological energy that we just don't have. It is important to face the fact that you can't control every possible adverse event. By accepting this fact of life, you can save your time and energy for those circumstances and events you can control and trade with the proper mental edge.

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Leslie Jouflas
Kelly Hill