1.

Introduction It has been discussed in many publications that the prices of securities actively traded on the open markets do not seem to be random. Many agree that because one can observe long, unidirectional moves in prices of lets say Dow Jones Industrial Index, those prices, therefore, must be a result of a cogniscent effort applied by majority of traders. Thus, a strong meaningful trend initiated by the most insightful market participants is a lot more significant subject to study than the randomness of the prices that would just simply pollute the picture. Proponents of this approach usually refer to what is called Black Monday an event on the markets that had such a low probability that it should not have happened at all during this relatively short time of markets existence of 300 years or so. Not that these events do happen, they happen quite frequently which is completely impossible if we accept the pure randomness of the markets they say. Every self respected market analyst, quant or fund manager is aware of Black Swans, Fat Tails, Black Mondays and other night mares that seem to make markets a lot more dangerous place than it is acceptable by the followers of the Market Efficiency theory. Fund managers read The Miss-Behavior of Markets by the founder of the Fractal Geometry Dr. Mandelbrot and sweat over their market exposed portfolios. They rush to buy protective puts and calls to sleep well. They believe that because planes still fly into the buildings these days there is only one way to protect their holdings it is to spend money on the old-fashioned but reliable insurance policies. Market risks are so over exaggerated that the risk management of investment portfolios became very similar to the paranoia of the Cold War in 70s and 80s. And as Cold War has prompted governments to spend billions of dollars on their defense systems our Modern Theory of Portfolio Risk Management demands spending of up to 80% of all the potential profits on the insurance policies (which benefits, as usual, only insurance companies). When talking these days about fundamental principals that govern modern markets it is distasteful to even suggest that they are still as random as they were 300 years ago. More so, suggesting that markets do obey Gaussian (Normal) law of distribution observed on its price fluctuations is like saying that the speed of light might not be the limit with which matter travels through space pure insanity! How could it be that the result of the very well thought through process of buying and selling securities by very astute market analysts, traders, fund managers and savvy speculators still is exactly the same as the result of monkeys hitting keyboards of those trading computers? Well, it is a very good question so is the question How does the Moon know that it should follow its orbit? or How does the rain drop know that it should maintain its shape? or even How does the population of rabbits know to keep its size as such that every rabbit would have just enough food to survive? While writing these words we are definitely aware of the fact that most believe in opposite. Look at the S&P 500 Index chart of the past 30 40 years! They say Its not Gaussian at all! Its power law at best; it has been rising overall all of these

years! It has jumps that cannot be fitted to the Gaussian distribution curve because they are 40 45 standard deviations large! Well, are they? We think, we can offer a different point of view that may just do what the Theory of Relativity did to the famous Newtons laws corrected them. We will also try to establish the patterns in market price series that maintain constant through the rise and fall of companies, through the turbulence of 80s and the dot com rush of the late 90s. We will try to show that Black Mondays (Black Fridays and all of the other Fat Tails) are not anomalies, but a very predictable norm. We also hope to demonstrate that the establishing of those stable patterns of randomness is a fruitful foundation for a constructive method of the investment portfolio management. More so, we shall try to demonstrate that so-called intellectual collective behavior of the market participants is nothing else but a stable (stationary) random process that has a very high degree of predictability. 2. Stable Random Processes There are a lot of random processes that unfold in time approximately uniformly and exhibit them selves as fluctuations over some sort of an average level. These processes have constant average amplitude and a permanent character of their development. These kind of random processes are called stationary or stable. Good examples of stable processes are: rocking of the boat on the windy lake driving a car on a straight highway Voltage fluctuations in the power receptacle

Any of the stable processes could be viewed as processes that are developing for indefinitely long time or, in other words, having no beginning or end. On another hand, there are non-stationary (non-stable) processes that display characteristics that are different on each of the stages of their development. Examples of non-stable processes include explosions of any kind, diseases, social revolutions and processes of discoveries. It is important to mention that not all of the non-stable random processes are significantly non-stable. It means that many of them could be stable during a portion of their overall development time. For example, a process of flying from Toronto to London can be very non-stable during the take off and landing but could be considered as stationary during the flying over the Atlantic Ocean. The significance of the classifying a process as a stable one comes from the fact that if an observer believes that a process is stable then he or she could predict certain events prompted by this process with a grater degree of certainty. The observer can make reliable bets about upcoming events resulting from this process or make predictions about what could happen over a certain period of time. For example: if an electrician knows that the average voltage in the receptacle is 120 VAC then if he at some point of time registers 117VAC he can say that the voltage should rise up to at least 120VAC sometimes in the future. If the voltage in this receptacle is stable (stationary) then his prediction will have extremely high probability of being correct

especially if he does not limit the time of when this correction of the voltage will take place. Another good example of stationary processes could be a process of every day eating by some individual. This process could be considered as a stable one during the life time of an individual. The most intriguing stationary process that happens to be our favorite one is the behavior of an individual or a group of individuals (including society at large) that is restricted by a system of strong beliefs or faith. A common sense based or a rational type of behavior usually has a very high level of stability over a considerably long period of time. A complex structure of reflexes, habits, social norms, rituals and beliefs makes the human behavior one of the most stable random processes that one could observe in nature. Trading markets is one of those behaviors that we shall prove to be stationary further in this paper. A random process X(t) is a stable one if none if its characteristics depend on t . Characteristics like Probability Density, Distribution, Mathematical Expectation (Mean), Correlation and Dispersion are invariant to t in stable random processes. So, one could say that stable processes have constant mean: m x (t ) = m x = Const. If this is true for a random process then this process behaves similarly to an oscillation over its m x . It is easy to show that any random process with constant m x could be transformed into a similar random process with m x = 0. This kind of processes is called Zero Balanced processes. Looking further into it one could easily observe that if a random process has variable but known m x (t ) it would not interfere with treating this process as a stable one. This could be easily achieved by constantly offsetting the characteristics of this random process by current value of m x (t ) . Example: If an observer measures the brightness of a battery powered flashlight over a few hours of its operation a couple of things becomes apparent: 1. Overall average brightness of the flash light steadily declines due to the battery drain 2. Short-Term fluctuations of its brightness due to natural vibrations of the bulbs filament have constant amplitude over the average level of its brightness. In this experiment the high frequency brightness fluctuations over an average level of the brightness is a Zero Balanced Stable Random Process (ZBSRP), where the absolute level of brightness over lets say five hours of continues operation is nonstationary random process. It is fairly easy to establish the function that accurately describes the light level decay for a battery operated flash light (both theoretically and empirically). So, if an observer can accurately predict the average level of the flash light brightness at any given point of time he can easily exclude this information from his observations and focus only on the character of high frequency light vibrations. In this experiment those vibrations have the distribution of

brightness variations that is purely Gaussian where the absolute brightness levels are definitely not. Price representation in the units of its volatility The behavior of large collectives of people has been studied for years and it is a well established fact that neither logic nor experience of individuals plays any role in the overall behavioral patterns observed in their common activities. The same holds true for trading collectives where large amounts of traders dispersed all over the world are performing simultaneous betting on the price movements of any given security. This traders activity forms a collective behavioral pattern that is completely irrelevant to the level of information that each of the individual traders possesses their knowledge or prior trading experience. This phenomenon reflects in the security price behavior making it more predictable. Below is the 45 years long daily price chart of S&P 500 index

It is not difficult to see that the daily price distribution is far away from being normal (Gaussian). However the picture is dramatically different if the same price movement is presented in the price volatility units measured daily. Below is the same

price chart represented in what we call Volatility Quantum Units (VQU). VQU is similar to the ATR with the adjustments for the tick values.

This representation of the price movement accurately depicts the character of the collective behavior that traders exhibited over the time span of 45 years. Taking the above price pattern and measuring the distribution of the price changes over their mean value gives us almost perfect Gaussian distribution presented on the picture below.

Similar results were established in more than 200 different securities including currencies, stocks, futures etc. Also, we were able to prove that the same patterns exist in the time frames ranging from seconds to weeks, from hundreds of ticks to thousands of ticks etc. It has been also established that for each time frame there is a permanent relationship between the length of the price time window and its VQU value.