Random Walk Theory of Share Price Movements - Essay Example

A lot many efforts were made towards identifying a predictable trading pattern which could be used for chasing profitable deals. From the mid-1950s to the early 1980s, a random walk theory (RWT) of share prices was developed based on the past empirical evidence of randomness in share price movements. RWT basically stated that speculative price changes were independent and identically distributed, so that the past price data had no predictive power for future share price movements. RWT also stated that the distribution of price changes from transaction to transaction had finite variance.

In addition, if transactions were fairly uniformly spread across time and were large in numbers, then the Central Limit Theorem suggested that the price changes would be normally distributed. Kendall (1953) calculated the first differences of twenty-two different speculative price series at weekly intervals from 486 to 2,387 terms. He concluded that the random changes from one term to the next were large and obfuscated any systematic effect which may be present. In fact, he stated that 'the data behaved almost like a wandering series' (random walk).

Specifically, an analysis of share price movement revealed little serial correlation, with the conclusion that there was very little predictability of movements in share prices for a week ahead without extraneous information. In 1959, Roberts generated a pattern of market levels and changes akin to actual levels and changes in the Dow Jones Industrial Index. He estimated the probability of different share price movements over time by using a frequency distribution of historical changes in the weekly market index, and assumed weekly changes were independently drawn from a normal distribution with a mean of + 0.

5 and a standard deviation of 5.0. He concluded that changes in security prices behaved as if they had been generated by a simple chance model .The fundamental concept behind random walk theory is that competition in perfect markets would remove excess economic profits, except from those parties who exercised some degree of market monopoly. This meant that a trader with specialized information about future events could profit from the monopolistic access to information, but that fundamental and technical analysts who rely on past information should not expect to have speculative gains.

From the theory of random walks arose the theory of efficient markets. The Efficient Markets Hypothesis (EMH) states that current prices always 'fully reflect' available information, so that the only reason prices change between time t and time t+1 is the arrival of new information. The EMH requires that only two necessary conditions be met. First, the market must be aware of all available information .The type of information available is determined by the strength of the EMH being tested.

In a Weak Form EMH, current prices entirely reflect all that can be known from the study of historical prices and trading volumes. If the Weak Form is valid, technical