Stochastic Nature of the Markets

It may seem like the markets are deterministic, especially when trends are strong and long lasting. But they are not. One minute a trend is doing one thing and the next minute its gone. As a result, it is almost impossible to predict with certainty what will happen. Worse, even what appears to be exactly the same set of starting conditions can lead to different outcomes. This is the essence of a stochastic environment. If you cannot accept this, you should simply stop reading now, and return once you’ve had enough experience in the markets to understand this.

But…why are the markets stochastic? After all, there are many participants in the markets, and they all have access to the same information. Why don’t they all act the same way, leading to a deterministic outcome, based on the same data? Unfortunately for us, there are an infinite number of reasons, but they tend to fall into several buckets. Examples are news, the speed of news, sentiment, psychology, randomness, herd mentality, external factors, complexity, market makers and so on. With so many inputs and reactions for the markets to operate on, it is no wonder that the markets are not deterministic.

That said, there are probabilities and patterns that can be exploited. While the next move cannot be predicted with certainty, the likelihood of any number of potential next moves can, along with worst case and best case scenarios. It’s less about expecting any one next outcome to happen, and more about understanding the possibilities of several potential outcomes.