SK Biswal Chief Engineer at ONGC. Interested in Stock option trading ,Technical Analysis of Stocks & Commodities

Understanding The Background Of Random Price Behavior

3 min read

Randomness  and Efficient Price Discovery

Random-walk theorists usually start from the premise that the major security exchanges are good examples of “efficient”markets. An “efficient” market is defined as a market where there are large numbers of rational profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants.

random walk and brownian motion

 
In an efficient market, competition among the many intelligent participants leads to a situation where, at any point in time, actual prices of individual securities already reflect the effects of information based both on events that have already occurred and on events which as of now the market expects to take place in the future. In other words, in an efficient market at any point in time the actual price of a security will be a good estimate of its intrinsic value.

 Now in an uncertain world the intrinsic value of a security can never be determined exactly. Thus there is always room for disagreement among market participants concerning just what the intrinsic value of an individual security is, and such disagreement will give rise to discrepancies between actual prices and intrinsic values. In an efficient market, however, the actions of the many competing participants should cause the actual price of a security to wander randomly about its intrinsic value. Although uncertainty concerning intrinsic values will remain, actual prices of securities will wander randomly about their intrinsic values.

If the discrepancies between actual prices and intrinsic values are systematic rather than random in nature, then knowledge of this should help intelligent market participants to better predict the path by which actual prices will move toward intrinsic values.

 New Information and Noise

 Of course intrinsic values can themselves change across time as a result of new information.The new information may involve such things as the success of a current research and development project, a change in management, a tariff imposed on the industry’s product by a foreign country, an increase in industrial production, or any other actual or anticipatedchange in a factor which is likely to affect the company’s prospects.

In an efficient market, on the average,competition will cause the full effects of new information on intrinsic value to be reflected “instantaneously” in actual prices. In fact, however, because there is vagueness or uncertainty surrounding new information,“instantaneous adjustment” really has two implications. First, actual prices will initially overadjust to changes in intrinsic values as often as they will underadjust. Second, the lag in the complete adjustment of actual prices to successive new intrinsic values will itself be an independent, random variable, with the adjustment of actual prices sometimes preceding the occurrence of the event which is the basis of the change in intrinsic values (i.e., when the event is anticipated by the market before it actually occurs) and sometimes following.

 This says that the “instantaneous adjustment”property of an efficient market implies that successive price changes in individual securities will be independent. A market where successive price changes in individual securities are independent is, by definition, a random-walk market. Most simply the theory of random walks implies that a series of stock price changes has no memory-the past history of the series can not be used to predict the future in any meaningful way. The future path of the price level of a security is no more predictable than the path of a series of cumulated random numbers.

REALITY Vs IDEAL

Independence of price as assumed in random process is naïve to be believed to be norm in market today.In fact it is exactly other way round.Rigging and manipulation are given and are successful business strategy today.There is nexus and collusion everywhere.Market is less free and more controlled for the cronies ,by the cronies and of the cronies.All kinds of markets tend to be fixed left and right sooner than later like more familiar match fixing .In fact this strategy has emerged as most efficient and easy way to make mullah in quickest possible time.Simply look at cricket matches’ outcomes which are supposed to be random.Outcomes of matches are also  supposed to be independent –a key character of typical random event . Is it really so ? So is the case with price of anything traded in any market .Bids of contracts are easily manipulated whatever be the mode of auction.Whether it is bus fares, school tuition fees or house rents in city or onion prices ,you hardly find any evidence of independence.Everything seems to have been fixed efficiently.What strikes most is wide spread collusion of vested interests with sophisticated networking with Tips and SMS alerts.Coupling ,nexus , cartelization which rendered price as remote controlled not a random aspect any more .So Ideal random assumptions retain only thin semblance in reality for any market.

 

 CONCLUSION

It is unlikely that the random-walk hypothesis provides an exact description of the behavior of stock-market prices. For practical purposes, however, the model may be acceptable even though it does not fit the facts exactly. Thus, although successive price changes may not be strictly independent, the actual amount of dependence may be so small as to be unimportant. What should be classified as unimportant depends, of course, on the question at hand. For the stock-market trader or investor the criterion is obvious: The independence assumption of the random-walk model is valid as long as knowledge of the past behavior of the series of price changes cannot be used to increase expected gains. More specifically,if successive price changes for a given security are independent( in absence of any strong catalyst or crisis ahead or growing FII inflow or outflows), there is no problem in timing purchases and sales of that security. A simple policy of buying and holding the security will be as good as any more complicated mechanical procedure for timing purchases and sales. This implies that, for investment purposes, the independence assumption of the random-walk model is an adequate description of reality as long as the actual degree of dependence in series of price changes is not sufficient to make the expected profits of any more “sophisticated” mechanical trading rule or chartist technique greater than the expected profits under a naive buy-and-hold policy. The actual price of a security is any way going to wander randomly about its intrinsic value. So it is not possible to predict the path by which actual prices will move toward intrinsic values or to anticipate expected profits whether by chart pattern or any trading rule as per this hypothesis.

 

SK Biswal Chief Engineer at ONGC. Interested in Stock option trading ,Technical Analysis of Stocks & Commodities

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