A butterfly flaps its wings …a hurricane strikes miles away. According to Chaos Theory, a seemingly irrelevant action can precipitate, and contribute to, a major event. The right set of factors comes together and a major event takes place. It’s easy to imagine a fanciful chain of events that may initiate a market move. A housewife attends to her crying child who has tripped over the newspaper, and in doing so, leaves the refrigerator open during an unseasonably warm day. It breaks down, and the family needs a new one.
To get funds for a new refrigerator, she sells off a large chunk of IBM stock that her parents gave her as a wedding present. By pure chance, at the moment that she sold the stock, a specialist monitoring the action gets it in his head that the sale of a large chunk of stock means something, so he sells off his positions in the tech sector. Next, a financial reporter sees the sale and tries to interpret it. He reports that it reflects a shortage of silicon and suggests investors unload their tech stocks immediately.
Many people follow his advice and a massive sell-off takes place. Perhaps it seems a little unlikely that all of this can happen, but you get the idea. Just like how scientists claim, according to Chaos Theory, that a butterfly can start a hurricane, you can imagine that a few key seemingly minor events can start a major market move.
Many investors view the markets from a traditional long-term buy-and-hold strategy. They look at the markets in terms of fundamental variables, such as consumer confidence, demand, and general economic factors that impact a stock price. If a company makes profits that are in high demand, the price goes up. Short-term investors, though, realize that many market moves are the result of psychological factors, such as opinions or emotions of fear and greed. In the short-term, anything can happen, and it’s vital to keep this in mind.
Nothing is certain in the markets, but is this something to worry about? Not if you take precautions. Indeed, a potentially chaotic event can be a good thing. The initial event that set off a market move isn’t important. Who cares why the masses buy or sell, for example, as long as you take advantage of the move? Some may view such moves as excellent opportunities to profit. On the other hand, if you have a swing trade that is ruined by an unexpected adverse event, the chaotic nature of the markets can be a hassle. But such events still aren’t worth worrying about. All you have to do is anticipate them and take precautions. By using a protective stop, for example, you can avoid losing capital when an adverse event unexpectedly occurs.
In the end, it’s necessary to accept the risky nature of trading. Anything can happen, but it doesn’t need to be a source of worry. Through careful risk management, you can protect your capital. And occasionally, an unexpected event can turn a mundane trade into a big winner. Worry can be the doom of many traders, but if you accept the fact that uncertainty and chaos are part of the inherent nature of the markets, you can account for it in your trading plan, and neutralize its potentially negative impact.