A:

The chaos theory is a complicated and disputed mathematical theory that seeks to explain the effect of seemingly insignificant factors. The chaos theory name originates from the idea that the theory can give an explanation for chaotic or random occurrences. The first real experiment in the chaos theory was done in 1960 by a meteorologist, Edward Lorenz. He was working with a system of equations to predict what the weather would likely be.

In 1961, he wanted to recreate a past weather sequence, but he began the sequence mid-way and printed out only the first three decimal places instead of the full six. This radically changed the sequence, which could reasonably be assumed to closely mirror the original sequence with only the slight change of three decimal places. However, Lorenz proved that seemingly insignificant factors can have a huge effect on the overall outcome. The chaos theory explores the effects of small occurrences dramatically affecting the outcomes of seemingly unrelated events.

The chaos theory has been applied to many scientific areas, including finance. In finance, the Chaos theory has been used to argue that price is the last thing to change for a security. Using the chaos theory, a change in price can be determined through mathematical predictions of the following factors: a trader's personal motivations (such as doubt, desire or hope that are nonlinear and complex), changes in volume, acceleration of changes and momentum behind the changes. The application of the chaos theory to finance remains controversial.

For more information on stock theories see The Basics Of Game Theory and Modern Portfolio Theory: An Overview.

This question was answered by Bob Schneider.

RELATED FAQS
  1. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  2. Is a good's production cost related to its value?

    Learn about the history and debate regarding the metrics used to determine the value of a good and which theories place emphasis ... Read Answer >>
  3. What is capital structure theory?

    Discover capital structure theory as it relates to financial management and the methods in which companies attempt to raise ... Read Answer >>
  4. How does money supply affect inflation?

    Learn about two competing economic theories of the role of the money supply and whether money supply necessarily causes inflation ... Read Answer >>
  5. What is the "random walk theory" and what does it mean for investors?

    The random walk theory is the occurrence of an event determined by a series of random movements - in other words, events ... Read Answer >>
  6. How has the Internet contributed to the long tail theory of marketing?

    Learn how the Internet has contributed to the long-tail theory of marketing and how this strategy is being applied by modern ... Read Answer >>
Related Articles
  1. Investing Basics

    Modern Portfolio Theory vs. Behavioral Finance

    Modern portfolio theory and behavioral finance represent differing schools of thought that attempt to explain investor behavior. Perhaps the easiest way to think about their arguments and positions ...
  2. Investing News

    Globalization and the Butterfly Effect

    Discover how the butterfly effect applies to global capital markets and witness how chaos theory can describe market volatility.
  3. Investing Basics

    Understanding the Random Walk Theory

    The random walk theory states stock prices are independent of other factors, so their past movements cannot predict their future.
  4. Active Trading

    Manipulating Facts to Fit a Theory: A Dangerous Trading Practice

    This practice is common with experienced and new traders, and it can lead to huge losses. Find out how to avoid it.
  5. Term

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
  6. Economics

    Efficient Market Hypothesis

    An investment theory that states it is impossible to "beat the market".
  7. Active Trading Fundamentals

    Dow Theory: Introduction

    By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.comAny attempt to trace the origins of technical analysis would inevitably lead to Dow theory. While more than 100 years old, ...
  8. Economics

    Prisoner's Dilemma

    Learn more about this classic game theory scenario.
  9. Active Trading Fundamentals

    Dow Theory: The Market Discounts Everything

    By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.comThe first basic premise of Dow theory suggests that all information - past, current and even future - is discounted into ...
  10. Active Trading Fundamentals

    Dow Theory: Dow Theory Specifics

    By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.comSo far, we have discussed a lot of the ideas behind Dow theory along with its main tenets. In this section, we'll take a ...
RELATED TERMS
  1. Accelerator Theory

    An economic theory that suggests that as demand or income increases ...
  2. Biased Expectations Theory

    A theory that the future value of interest rates is equal to ...
  3. Random Walk Theory

    The theory that stock price changes have the same distribution ...
  4. Dow Theory

    A theory which says the market is in an upward trend if one of ...
  5. Demand Theory

    A theory relating to the relationship between consumer demand ...
  6. Expectations Theory

    The hypothesis that long-term interest rates contain a prediction ...
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center