Stochastic Modeling

Stochastic Modeling is a process in which we try to track, or possibly predict, the behavior of a whole series of inter-connected variables. Typically, a simulation will be created that models the behavior of a variable we’re interested in tracking, like the future price or possible returns on an investment.

This variable will almost depend on a whole variety of other variables, like confidence in the company, the financial position of the company, the overall market performance, etc. We’ll run the simulation with a certain set of initial conditions and determine the resulting effect on our stock price. We’ll then slightly, or even drastically, change one or more of those initial conditions and re-run the simulation. We’ll keep doing this over and over to get a whole profile of predicted values for our variable. Analyzing that profile can give us insight into how the stock price might actual shake out in the end.

Example:

Dirt, Inc.’s stock has been rising pretty steadily over the last six trading days, since they announced a breakthrough in their dirt production process...which has led to tons of investors jumping on board as buyers driving up the price. You want to hitch your wagon to the gravy train.

But what if the price gains are slowing? In other words, the price is still increasing, but increasing by less and less each day, indicating that the stock is possibly reaching a maximum value before recorrecting downward? If we could also measure the rate at which the prices are changing, we might be able to predict when or if the price is going to reach a maximum value.

Now say you’re the getaway guy for a bank robbery, but the pressure gets to be too much for you, and you take off. Now, what if we not only track the speed of your car, but also the rate at which the speed is changing? Your car might still be speeding up from 50 mph to 60 mph to 65 mph to 67 mph, but it’s speeding up at a slower and slower rate. The decreasing rate at which the speed is changing indicates that you, the driver, might be reaching a top speed soon. We stress the “might” because it’s not a guarantee here...nor is it a guarantee in forecasting future movements.

So, getting back to stocks. It’s absolutely true that changes in the rate of change of a stock price can often precede the stock price reaching a highest or lowest point...or even topping out and then dropping or bottoming out, and then rising. Stochastic analysis is a great way to forecast possible price changes. We’re getting a look under the hood of the stock... not just at the actual performance of the stock, but at the rate at which that performance is changing. Effectively, we’re getting not only a look at the way the stock looks in the mirror, but also a look at its inner workings. Like an x-ray. What we see in the mirror is just a chart of closing prices plotted over time. What we see in the stochastic analysis x-ray machine is a measure of the rate at which those prices are changing.