Why Stock Market Predictions?
Stock market predictions have always been the subject of curiosity and even the first wish of every investor and trader. Of course for me also. This first desire and curiosity is due to the nature of the stock market.
Because the stock market gives equal opportunities to all but behaves differently according to the stock market predictions. And any person can make a lot of money if he/she is able to correctly predict the stock market. He/she can even become the richest person in the world.
Challenges of Stock Market Predictions
But this has not happened till date. The reason is simple, that the future is unpredictable.
Even though Sir Warren Buffett has become one of the richest men in the world, it is not only because of these prophecies. This is also due to his own developed system through his foresight and value investing.
Surprisingly, many theories and procedures have been developed and adopted for forecasting the stock market. But none of these theories are fully capable of predicting the stock market.
People also resort to astrology for this. (But I do not know much about it.)
Nowadays, during the development of artificial intelligence, the latest technologies such as LSTM and Deep Learning Algorithms are being used in portfolio management and forecasting stock price movements.
Although these techniques are more accurate. But this too, not every time. Because there are many random and noisy things/data in the market that are uncertain and unpredictable. It is the nature of the stock market that makes it a non-parametric and non-linear system.
News about the results of a company, GDP, inflation or unemployment rate, changes in policies or taxes by the government or any decision taken by the central bank, fluctuation in oil prices, trade wars, etc. influence the stock market to a greater extents.
Sometimes, rumors or a scam related to a stock or stock market also lead to an unexpected movement of the market. You must have now become clear how challenging it is to fully predict the stock market!
Therefore, the question arises as to why we have been trying to forecast the stock market when stock market forecasting is impossible.
Feasibility of Stock Market Predictions
According to the efficient market hypothesis -“it is not possible to predict stock prices with perfection as it is a random walk.” But all the successful names around the world such as Warren Buffet, Jim Simons, Jeff Glickman, Rakesh Jhunjhunwala, etc. have created a saying that success in the market requires more probability of correct predictions and conviction rather than perfection.
Broadly, the probability of a correct prediction of 3/4, which is also 75%, is sufficient to become a successful investor or trader in the stock market.
Furthermore, we now have a large amount of data available that can be formulated in various suitable algorithms and processed in an advanced technological environment.
Another important point that supports the feasibility of stock market predictions is the psychology of investors. Our behavior in the stock market is based on fear and greed. Which are repetitive in nature.
Obviously you too should learn stock market predictions.
Let’s find a better way.
Before discussing the methods of stock market forecasting, it is worth knowing what is the time horizon during stock forecasting to make investment and trading profitable.
Role of Time Horizon during Predictions
Without considering time horizon it is meaningless to predict stock market. The prices of all financial instruments related to the stock market vary from moment to moment according to their tick size. Their values are both falling and increasing.
We invest for different time periods. There are also time related conditions for trading in shares or indices. In futures and options trading, the deal has to be squared-off within a certain period of time.
Market data is represented on a different time scale according to the duration of the trade. So that we can come to the right conclusion. Therefore, it is very important to take care of the time horizon while doing stock market prediction.
Wrong Behavior Towards Stock Predictions
I believe that predicting the next move of any financial instrument in the stock market when we do it randomly proves to be utter nonsense.
I have seen many people predict market and stock price without adopting any system of stock prediction. They also trade without analysis. This is not their belief, this is the wrong behavior of stock trading.
Because then people give up analysis and conviction and start speculating. They begin to prove to themselves that their prediction was correct. And they find excuses in case of mistake. Which turns them away from their real purpose.
Methods of Stock Market Predictions
There are certain and different theories for predicting stock price that can be classified in two broad ways-
- Traditionally well-established methods and
- Intelligent trading systems based on modern techniques.
Traditional Methods of Stock Market Predictions
These methods are still very popular and fruitful for predicting stock prices well. They may have a similar or completely different approach from each other.
a) Fundamental Analysis
Qualitative and quantitative analysis are the two major points of fundamental analysis. The main goal of this analysis is to estimate the real value of a company’s stock in comparison to the current market price of the stock.
The company is first analyzed qualitatively. We then derive various financial ratios by analyzing the company’s financial statements/annual reports and finally draw conclusions about the future growth of the company.
This analysis is not only useful for your long-term investment, but also protects you from wrong investment decisions.
Note: I suggest that you must read both these posts related to fundamental analysis- 1. Fundamental analysis of stocks and 2. How to analyze the balance sheet of a company.
Various assumptions during fundamental analysis do not make it suitable for your short term investment. The better you do a fundamental analysis of stocks, the better returns you can expect in the long run.
b) Technical Analysis
Technical analysis is relatively less suitable for long-term investment.
This is a great way of short-term investing or stock trading using a technical chart. While reading the chart you have to mainly focus on the price behavior, volume and technical indicators of the stock.
Technical analysts look at the chart to determine market trends. They study a variety of chart patterns such as candlesticks, bars, lines to estimate the breakout or breakdown of the stock price.
They predict market entry price and exit price by combining the best technical indicators. They try to know the support and resistance of any share price by technical analysis.
c) Option Chain Analysis
Option chain analysis has also become a good way to know the market outlook or the direction of a stock price. By this you can find out about stocks or indices that are involved in futures and options trading.
In option chain analysis, you see the position made by bulls and bears by looking at some particular figures. Changes in open interest and volume are in prime focus when analyzing the option chain with the scrip price of certain strike price.
The option chain data is provided by the Stock Exchanges.
d) Dow Theory
The Dow theory can be considered the core of technical analysis used today. In Dow theory, the ideas are those of Charles H. Dow. But it is collectively derived and summarized by Hamilton, Rhea, and Shaffer.
Even such old theory has maintained its usefulness till date. The six main components of Dow theory are as follows –
- The Market Discounts Everything
- There Are Three Primary Kinds of Market Trends
- Primary Trends Have Three Phases
- Indices Must Confirm Each Other
- Volume Must Confirm the Trend
- Trends Persist Until a Clear Reversal Occurs
Source: Investopedia (See for details- terms/d/dowtheory)
e) Elliott’s Wave Principle
The Elliott wave principle is a form of technical analysis that finance traders use to analyze financial market cycles and forecast market trends by identifying extremes in investor psychology, highs and lows in prices, and other collective factors.
source: Wikipedia (See for details- Elliott_wave_principle)
Sir Elliott in his model had tried to define the psychology of crowd’s greed and fear in terms of optimism and pessimism that occurs in natural way.
In Elliott’s model price movements is supposed to occur as waves which forms a pattern. These waves are-
Impulsive or Motive Waves– these are a set of 5 smaller waves out of which two are retracing waves.
Corrective Waves– these are made up by 3 smaller waves like impulse-retrace-impulse.
In a bull market motive waves are dominant in upward direction followed by corrective waves. But in bear market the situation reverses i.e. impulsive waves are dominant in downward direction followed by corrective waves.
Actually, Elliott wave principle can be assumed based on Fibonacci Sequence but Sir Elliott had developed his model without the knowledge of Fibonacci Series.
However this theory gives a good picture of market trends and able to make stock market prediction on macro level but analysts are still debating about this.
Intelligent Trading System for Stock Predictions
There is no doubt that intelligent trading system will prove to be more accurate and efficient than traditional methods. But it is still evolving. However, Algo Trading is a good example of intelligent trading system which is becoming popular in the market.
a) Stock Market Calculator
My experience with the stock market calculator has been very deep and brilliant. Look what I made!
This calculator is awsome for day trading/ intraday trading. It is a combination of Fibonacci sequences, golden ratios and mathematical operations in computer language.
Despite the accuracy, it also has some limitations. It does not explain the trend of share price. But it calculates all possible targets for both trends in the market for any financial instrument. I am working hard to make this calculator useful for long term investment.
b) Hidden Markov Models
Since the stock market is a part of financial time series that are non-stationary. Thus there was a need for non-stationary series models. And for this, the Hidden Markov Models (HMMs) can be considered a great start. Which is now being used to solve and predict real problems in many areas.
The father of HMM, a very relevant statistical theory, was a Russian mathematician Andrey Andreyevich Markov. Which was further introduced and proposed by Baum and Petrie in 1966.
It works on the concept that there can be many hidden parameters (hidden states) based on observation. Which are difficult to find and understand by human brain through observations. And with the help of Markov’s model, complex probability-statistical calculations, we are able to identify hidden parameters.
Which are still hidden but it is possible to predict the results from further analysis.
It is very interesting to learn the Hidden Markov Model with greater accuracy for stock market prediction, but it requires your hard work to understand and apply it. Especially for me.
I think it is not appropriate to describe the basic elements of a hidden Markov model here and their definition. You and I need to learn this separately.
c) Predictions using Machine Learning
Artificial Intelligence (AI) seems to be the most effective technique ever. However, new experiments and improvements are being made in this technique every day. Companies like Google, Tesla, etc have started using it successfully in many fields.
The future of stock trading is about to happen through AI-driven analysis. Many financial institutions around the world are using AI for better stock trading and higher returns in many ways.
Trading Technologies from Chicago, KAVOUT from Seattle, Wash., AUQUAN from London and EPOQUE from Switzerland, etc are some of the companies using Artificial Intelligence in stock trading.
Google Colaboratory is a great platform from where you can start learning Machine Learning/AI.
This technique is mainly an elaborate form of machine learning and deep learning. In which millions of data points are fed through computer coding Python using various algorithms based on appropriate network technology.
Artificial Neural Networks (ANNs), Recurrent Neural Networks, Long Short-Term Memory (LSTM) and Support Vector Machine (SVM) are popular methods of using data points in the form of tick data or different periods.
Which makes Artificial Intelligence like a human brain first to learn and then reprogram itself to take a decision and make a stock prediction.
CONCLUSION
Whatever method of stock market forecasting we have discussed is not perfect. It is also true that the machine learning method can be more efficient and accurate than the traditional method.
On the one hand, Jim Simons, a mathematician, made the financial market aware of the importance of Artificial Intelligence by the success of Renaissance Technologies, on the other hand Warren Buffett has brought his success in the stock market with fundamental analysis and the concept of value investing.
There are too many problems with using machine learning method to overcome the shortcomings of traditional methods of analysis. The stock market is 100% efficient and therefore completely unpredictable.
There are a lot of external factors that can never be included to predict any theory. And you can certainly use these methods to supplement your decision-making in the stock to boost your returns.
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