Mathematical Modeling in Finance with Stochastic Processes

(Ben Green) #1

4.4. THE ABSOLUTE EXCESS OF HEADS OVER TAILS 153


0 .07 to calculate thatP[X 1 ]< 0 ≈ 0 .47210, or about 47%. Alternatively,
if we assume that the individual changesXiare binomial random variables
withP[X 1 = 1] =p, thenE[X 1 ] = 2p−1 and Var [X 1 ] = 4p(1−p). We can
use 2p−1 =E[X 1 ] = 0.07 Var [X 1 ] = 0. 07 ·(4p(1−p)) to solve forp. The
result isp= 0.53491.


In either case, this means that any given piece of advice only has to have
a 53% chance of being correct in order to have a perpetual money-making
machine. Compare this with the strategy of using a coin flip to provide the
advice. Since we don’t observe any perpetual money-making machines, we
conclude that any advice about stock picking must be less than 53% reliable
or about the same as flipping a coin.
Now suppose that instead we have a computer algorithm predicting stock
movements for all publicly traded stocks, of which there are about 2,000.
Suppose further that we wish to restrict the chance thatP[Xannual]< 10 −^6 ,
that is 1 chance in a million. Then we can repeat the analysis to show that
the computer algorithm would only need to haveP[X 1 ] < 0 ≈ 0 .49737,
practically indistinguishable from a coin flip, in order to make money. This
provides a statistical argument against the utility of technical analysis for
stock price prediction. Money-making is not sufficient evidence to distinguish
ability in stock-picking from coin-flipping.


Sources


This section is adapted from the article “Tossing a Fair Coin” by Leonard
Lipkin. The discussion of the continuity correction is adapted from Partial
Sums and the Central Limit Theorem in the Virtual Laboratories in Prob-
ability and Statistics. The third example in this section is adapted from a
presentation by Jonathan Kaplan of D.E. Shaw and Co. in summer 2010.


Problems to Work for Understanding



  1. (a) What is the approximate probability that the number of heads is
    within 10 of the number of tails, that is, a difference of 2% or less
    of the number of tosses in 500 tosses?
    (b) What is the approximate probability that the number of heads is
    within 20 of the number of tails, that is, a difference of 4% or less
    of the number of tosses in 500 tosses?

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