How is probability used in the stock market and in business?
Posted by admin in Finance Monday, 11 April 2011 07:35 3 Comments
I am writing a paper on the subject of probability (I am only in high school, so my knowledge of probability theory is extremely basic.) Would some one be able to explain to me simply how probability theory is used in stock markets?
Often probability is used in a very simple binomial model for stock valuation. Basically, we consider the expected return of a stock or security and we look at how it will perform in various states of the economy. Basically we say, the stock will pay: $50 in a Boom, $30 in a regular state and $0 in a Recession. Then we look at the probability of this outcome happening, say 25% of the time we see a Boom, 50% of the time we see a Regular/Plateau State and 25 % of the time we see a recession.
Therefore, the value today is (.25*50)+(.5*30)+(.25*0). The value we say is the expected return, in this case that is the sum of those terms, that is $27.50. It is important to consider the probability of each state occuring because otherwise we are left to assume that there is an equal chance of each state occuring.
For example, if you think that each state is equally likely, you will underpay/overpay based on the expected return and the rational price of a security should be its expected return.
That is a very simple model, but in theory it works and should suffice for the sake of your assignment. Also, Expected Return is the crux of financial valuation and highly relevant in the busines world.
An easier example might also be.
Say if you knew statistically how many points the Dow Jones Index moved a day. And in those statistics you saw that the Dow moved a certain number of points up and down a day from the open. Out of 250 trading days, a hundred days the price moved 80 to 100 points or 1% from open but then reversed and closed near opening price. i.e.
OPEN LOW HIGH CLOSE
10000 9900 10100 10004
on the other 100 days the price moved 200 points in one direction only.
on the other 50 days it moved 20 points from open and closed 20 points from open.
You could then say probability wise, when the price moves 80 to 100 points or (0.8% to 1%) from open there is x (probability) it will return to opening price.
You then base your trading decisions on this. i.e buy or sell.
Lot more to it but I hope that’s easy enough to understand .
Also Worth reading up on Ed Thorpe he applied probability theory allegedly very successful to Stock Markets.
first a layman starts thinking to invest . he invest in shares . ones he gets good value for shares he takes the profit .
if the share value comes down he buys again.buying and selling is known as business.