What is 'Chaos Theory'

Chaos theory is a mathematical concept that explains that it is possible to get random results from normal equations. The main precept behind this theory is the underlying notion of small occurrences significantly affecting the outcomes of seemingly unrelated events. Chaos theory is also referred to as "non-linear dynamics."

BREAKING DOWN 'Chaos Theory'

Chaos theory has been applied to many different things, from predicting weather patterns to the stock market. Simply put, chaos theory is an attempt to see and understand the underlying order of complex systems that may appear to be without order at first glance.

The first real experiment in 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 midway 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. Chaos theory explores the effects of small occurrences dramatically affecting the outcomes of seemingly unrelated events.

Chaos theory is highly controversial and extremely complicated. Related to financial markets, proponents of chaos theory believe that price is the very last thing to change for a stock, bond or some other security. Price changes can be determined through stringent mathematical equations predicting the following factors:

1. A trader's own personal motives, needs, desires, hopes, fears and beliefs
2. Volume changes
3. Acceleration of the changes
4. Momentum behind the changes

Core Factors Behind Chaos Theory

  • The Butterfly Effect: According to the Butterfly Effect, a butterfly in California can cause a hurricane in China if the butterfly flaps its wings at just the right point in space and time. While the result isn't immediate, the causal connection is real. The hurricane would not have happened if not for the butterfly. Expressed more generically, small changes in initial conditions can lead to drastic changes in final results. Human civilization is an ongoing demonstration of this principle in action. Who knows, for instance, what the long-term effects of teaching millions of people about chaos theory will be?
  • Unpredictability: Because all the initial conditions of a complex system are not fully knowable, it is impossible to predict the fate of a complex system. Even if all the conditions can be measured, slight errors in measurements will be amplified dramatically, rendering any prediction useless. This is why accurate long-range weather prediction will always remain impossible.
  • Order/Disorder: Chaos is not simply disorder. Chaos comprises the transitions between order and disorder, which often occur in surprising ways.
  • Mixing: Turbulence ensures that, in time, two adjacent points in a complex system will eventually end up in very different positions. For example, two neighboring water molecules may end up in different parts of the ocean or even in different oceans. A group of helium balloons that launch together will eventually land in drastically different places. Mixing is thorough because turbulence is non-linear and happens at all scales.
RELATED TERMS
  1. Expectations Theory

    The expectations theory uses long-term interest rates to forecast ...
  2. Mechanism Design Theory

    Mechanism design theory is an economic theory that seeks to study ...
  3. New Growth Theory

    New growth theory is a concept that presumes the desire and wants ...
  4. Butterfly Spread

    Butterfly spreads are a neutral option strategy, used to profit ...
  5. Rational Expectations Theory

    The rational expectations theory posits that individuals make ...
  6. Prospect Theory

    Prospect theory argues that if given the option, people prefer ...
Related Articles
  1. Investing

    Globalization and the Butterfly Effect

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

    Modern Portfolio Theory Vs. Behavioral Finance

    Or: How financial markets would work in an ideal world vs. how they work in the real world.
  3. Trading

    The Butterfly Spread

    A butterfly spread is a neutral options strategy with both limited risk and limited profit potential. The strategy involves four options contracts with the same expiration month but with three ...
  4. Managing Wealth

    Modern Portfolio Theory: Why It's Still Hip

    Investors still follow an old set of principles, known as modern portfolio theory (MPT), that reduce risk and increase returns through diversification.
  5. Insights

    The Basics Of Game Theory

    Take an introductory look at game theory and the terms involved, and get familiar with backwards induction, a simple method for solving games.
  6. Investing

    How to Create a Low-Risk, High-Return Portfolio

    Modern portfolio theory states diversification will create a lower-risk, higher-return portfolio.
RELATED FAQS
  1. What's the difference between agency theory and stakeholder theory?

    Agency theory and stakeholder theory are both used to understand and explain various types of relationships and challenges ... Read Answer >>
  2. How does money supply affect inflation?

    Learn about two competing economic theories of the role of the money supply and whether money supply causes inflation in ... Read Answer >>
  3. Has the Efficient Market Hypothesis been proven correct or incorrect?

    Explore the efficient market hypothesis and understand the extent to which this theory and its conclusions are correct or ... Read Answer >>
  4. Why is game theory useful in business?

    The concepts of game theory became a revolutionary interdisciplinary phenomenon, but they are still relevant for business ... Read Answer >>
Trading Center