The Physics of Stock Exchange

NY stock exchange traders floor
NY stock exchange traders floor. Source Wikimedia Commons

There are a lot of ways to make decisions about the purchase or the sale of shares and other financial assets at the stock exchange. Some of them are using concepts that proceed from physics, although they have not a clear physical basement to be used in that way, although we could find it.

An example can be the relative strength index. This index is calculated as the division of the market index over the asset price. This indicator drives to a comparison of the behavior of the asset and the market as a whole. In physical terms this index would be making a comparison between the energy of the asset and the energy of the market if you consider that money is similar to the energy that can be extracted if you sell the asset in that time to be applied for other activity. If you imagine a planetary system, any object has a certain amount of kinetic energy that depends on its speed. This energy could be transfer to other object due to a collision, in the same way as the price of a share can change if we sell it in order to buy another different asset of the market.

Other example can be the rate of change index (ROC). This index is calculated from the subtractions of the prices of consecutive days during a certain period of time. The index is calculated as the division of the addition of the positive subtractions over the addition of the negative ones. It lets us to determine if the asset is overbought or oversold. In physical terms this is analyzing if the energy stored in the asset have the trend to increase or to decrease. These subtractions would be related to the acceleration of a system of moving objects.

A similar indicator similar to the previous one can be the momentum that measures directly the acceleration or deceleration of the asset.  This indicator is calculated as the difference between two prices separated a certain number of days, typically five or ten days. The use of an indicator of the acceleration lets the investor to anticipate trends. An asset with low volatility would have a momentum curve similar to the price curve and a sudden change of the behavior of the price would be easily detected with the momentum.

If we think about these techniques for analyzing the stock exchange, we can see that they are assuming that the assets are closed subsystems. In physics, a closed system is a system that interchanges neither matter nor energy. They only can interchange energy inside the market interacting with the price of other assets. In other words, we are assuming that the price of the asset depends on how it interacts with the other prices of the assets. The decisions of purchase based on these indicators would depend on how we distribute the invested money among the assets of the market thinking that prices depend only on how other investors are making their investments. Intrinsic value would not be involved in the decision making process with these indicators.

A more perfect way to analyze the market would be to consider that the assets are opened subsystems, and they can interchange matter or energy out of the market. Kinetic energy depends on velocity and mass. The intrinsic value of the asset would be related to that mass and this value can change depending on the evolution of the business behind the asset.

Going farther, until now we have analyzed only the system from a classic physics viewpoint, however, we could introduce relativity to the analysis. In relativistic physics, mass change with the speed. The famous Einstein’s equation E =m c2, was obtained thinking that mass depends on velocity and there is a value m0 with a value of energy E0 for a coordinate system fixed to the object. This thinking would have economic sense because the evolution of a business and then its intrinsic value is related to the value of price of the shares too. Managers make many decisions about the company taking the price of the shares at the stock exchange into account.

After this little discussion, we can deduce that there is a need of additional indicators to consider the price of shares linked to the intrinsic value of the business behind the asset. Some useful indicators can be the business complexity and the market complexity. Complexity is an indicator that is a function of the internal factors that we use to define the value of a business. Market complexity would be analyzing how different companies are economically interacting among them too, for instance, some of them can be providers or clients of other ones, and how this is affecting the evolution market. Reducing the investments to a certain portfolio with a better certain complexity index than the market we can design a set of investments that can beat the market.


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