Chaos theory is the attempt to understand a complex system that, at first glance, appears to have no sense of order. Chaos theory can be applied to all sorts of things, from the weather to population growth to the spread of disease. It is a popular theory used for predicting trends within the stock market, as well.

In general, chaos theory is a mathematical concept that explains how random results are possible when using standard equations. The theory is that there are small occurrences that affect the outcomes, even though the events appear to be unrelated.

How Chaos Theory Works

Chaos, in the more common form of the word, means having no specific pattern or complete randomness. However, in its scientific version, which is the version used for determining chaos theory in finance, chaos is not random. Instead, it follows a specific pattern but allows for changes in the variables.

Because of the difficulty in determining chaos, it is easier to predict in long-term situations, rather than short-term ones. It is a non-linear form of mathematics because there are so many other variables at play. Behavior is a major factor in why the market works the way it does, which is why chaos theory is used in determining outcomes in the financial world. On the surface, chaos theory looks very orderly and smooth, but it is, in practice, chaotic, pulling information in from all directions with none of that information being exact. Chaos theory is based on what could happen, given all the information at hand and based on what has happened in the past.

It is a controversial theory because of the methods it must use to make a prediction.

Chaos Theory in the Financial Markets

It is believed that the last thing to change in the market is the price of a stock, bond, or mutual fund. Other factors, such as changes in an industry, social or political actions, and economic swings, will influence the market first. Price changes are determined through a set of mathematical equations that predict specific factors, which include volume changes, the acceleration of those changes, the momentum behind the changes, and the trader’s own personal motives.