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Normal in Vol Time

Normal in Vol Time

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Published by Igor

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Categories:Types, Research
Published by: Igor on Feb 28, 2012
Copyright:Attribution Non-commercial


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1. IntroductionIt has been discussed in many publications that the prices of securities actively tradedon the open markets do not seem to be random. Many agree that because one canobserve long, unidirectional moves in prices of let’s say Dow Jones Industrial Index,those prices, therefore, must be a result of a cogniscent effort applied by majority of traders. Thus, a “strong meaningful trend” initiated by the most “insightful” marketparticipants is a lot more significant subject to study than the “randomness” of theprices that would just simply “pollute the picture”. Proponents of this approachusually refer to what is called “Black Monday” – an event on the markets that hadsuch a low probability that it should not have happened at all during this relativelyshort time of market’s existence of 300 years or so. “Not that these events do happen,they happen quite frequently which is completely “impossible” if we accept the“pure randomness” of the markets” – they say. Every self respected market analyst,quant or fund manager is aware of “Black Swans”, “Fat Tails”, “Black Mondays”and other “night mares” that seem to make markets a lot more dangerous place thanit is acceptable by the followers of the “Market Efficiency” theory. Fund managersread “The Miss-Behavior of Markets” by the founder of the Fractal Geometry Dr.Mandelbrot and sweat over their “market exposed” portfolios. They rush to buyprotective puts and calls to sleep well. They believe that because planes still fly intothe buildings these days there is only one way to protect their holdings – it is tospend money on the old-fashioned but reliable insurance policies. Market risks are soover exaggerated that the risk management of investment portfolios became verysimilar to the paranoia of the Cold War in 70s and 80s. And as Cold War hasprompted governments to spend billions of dollars on their defense systems ourModern Theory of Portfolio Risk Management demands spending of up to 80% of allthe potential profits on the insurance policies (which benefits, as usual, onlyinsurance companies).When talking these days about fundamental principals that govern modern markets itis distasteful to even suggest that they are still as random as they were 300 years ago.More so, suggesting that markets do obey Gaussian (Normal) law of distributionobserved on its price fluctuations is like saying that the speed of light might not bethe limit with which matter travels through space – pure insanity! How could it bethat the result of the very well thought through process of buying and sellingsecurities by very astute market analysts, traders, fund managers and savvyspeculators still is exactly the same as the result of monkeys hitting keyboards of those trading computers? Well, it is a very good question so is the question “Howdoes the Moon know that it should follow its orbit?” or “How does the rain dropknow that it should maintain its shape?” or even “How does the population of rabbitsknow to keep its size as such that every rabbit would have just enough food tosurvive?”While writing these words we are definitely aware of the fact that most believe inopposite. “Look at the S&P 500 Index chart of the past 30 – 40 years!” – They say -It’s not Gaussian at all! Its power law at best; it has been rising overall all of these
years! It has jumps that cannot be fitted to the Gaussian distribution curve becausethey are 40 – 45 standard deviations large!” Well, are they? We think, we can offer adifferent point of view that may just do what the Theory of Relativity did to thefamous Newton’s laws – corrected them. We will also try to establish the patterns inmarket price series that maintain constant through the rise and fall of companies,through the turbulence of 80s and the “dot com rush of the late 90s”. We will try toshow that Black Mondays (Black Fridays and all of the other Fat Tails) are notanomalies, but a very predictable norm. We also hope to demonstrate that theestablishing of those stable patterns of randomness is a fruitful foundation for aconstructive method of the investment portfolio management. More so, we shall tryto demonstrate that so-called “intellectual collective behavior” of the marketparticipants is nothing else but a stable (stationary) random process that has a veryhigh degree of predictability.2. Stable Random ProcessesThere are a lot of random processes that unfold in time approximately uniformly andexhibit them selves as fluctuations over some sort of an average level. Theseprocesses have constant average amplitude and a permanent character of theirdevelopment. These kind of random processes are called “stationary” or “stable”.Good examples of stable processes are:-rocking of the boat on the windy lake-driving a car on a straight highway-Voltage fluctuations in the power receptacleAny of the stable processes could be viewed as processes that are developing forindefinitely long time or, in other words, having no beginning or end. On anotherhand, there are non-stationary (non-stable) processes that display characteristics thatare different on each of the stages of their development. Examples of non-stableprocesses include explosions of any kind, diseases, social revolutions and processesof discoveries. It is important to mention that not all of the non-stable randomprocesses are “significantly” non-stable. It means that many of them could be stableduring a portion of their overall development time. For example, a process of flyingfrom Toronto to London can be very non-stable during the take off and landing butcould be considered as stationary during the flying over the Atlantic Ocean.The significance of the classifying a process as a stable one comes from the fact thatif an observer believes that a process is stable then he or she could predict certainevents prompted by this process with a grater degree of certainty. The observer canmake reliable bets about upcoming events resulting from this process or makepredictions about what could happen over a certain period of time. For example: if anelectrician knows that the average voltage in the receptacle is 120 VAC then if he atsome point of time registers 117VAC he can say that the voltage should rise up to atleast 120VAC sometimes in the future. If the voltage in this receptacle is stable(stationary) then his prediction will have extremely high probability of being correct
especially if he does not limit the time of when this correction of the voltage willtake place. Another good example of stationary processes could be a process of every day eating by some individual. This process could be considered as a stableone during the life time of an individual.The most intriguing stationary process that happens to be our favorite one is thebehavior of an individual or a group of individuals (including society at large) that isrestricted by a system of strong beliefs or faith. A “common sense based” or a“rational” type of behavior usually has a very high level of stability over aconsiderably long period of time. A complex structure of reflexes, habits, socialnorms, rituals and beliefs makes the human behavior one of the most stable randomprocesses that one could observe in nature. Trading markets is one of those behaviorsthat we shall prove to be stationary further in this paper.A random process
is a stable one if none if its characteristics depend on
.Characteristics like Probability Density, Distribution, Mathematical Expectation(Mean), Correlation and Dispersion are invariant to
in stable random processes. So,one could say that stable processes have constant mean: )(
= Const.
If thisis true for a random process then this process behaves similarly to an oscillation overits
. It is easy to show that any random process with constant
could betransformed into a similar random process with
= 0
. This kind of processes iscalled “Zero Balanced” processes. Looking further into it one could easily observethat if a random process has variable but known )(
it would not interfere withtreating this process as a stable one. This could be easily achieved by constantlyoffsetting the characteristics of this random process by current value of )(
Example: If an observer measures the brightness of a battery powered flashlight overa few hours of its operation a couple of things becomes apparent:1.Overall average brightness of the flash light steadily declines due to thebattery drain2.Short-Term fluctuations of its brightness due to natural vibrations of thebulb’s filament have constant amplitude over the average level of itsbrightness.In this experiment the high frequency brightness fluctuations over an average levelof the brightness is a Zero Balanced Stable Random Process (ZBSRP), where theabsolute level of brightness over let’s say five hours of continues operation is non-stationary random process. It is fairly easy to establish the function that accuratelydescribes the light level decay for a battery operated flash light (both theoreticallyand empirically). So, if an observer can accurately predict the average level of theflash light brightness at any given point of time he can easily exclude thisinformation from his observations and focus only on the character of high frequencylight vibrations. In this experiment those vibrations have the distribution of 

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