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J. T. Manhire
Texas A&M University School of Law
WORKING PAPER
Abstract
This paper argues that one can calculate the probability of an assets price dis-
placement in a specific direction assuming the asset complies with the physical
principle of least action. It first suggests that the price displacement of a finan-
cial asset is essentially dampened harmonic motion and then applies physical
principles such as the Lagrangian and stationary action to analyze this motion.
From this analysis, the paper constructs a method to predict the probability
of an assets price displacement in both magnitude and direction. Initial tests
show that the method produces accurate probability predictions.
1. Overview
This paper seeks to show that the probability of an assets price displace-
ment in a specific direction can be calculated assuming the asset complies with
the physical principle of least (i.e., stationary) action. We hypothesize that,
just as in classical mechanics, the action of an asset is the time integral of
its Lagrangian, which is simply a collection of the assets equations of motion
expressed in terms of position and velocity.
Others have postulated that analyzing an objects motion using the La-
grangian method and its stationary action can accurately predict the probability
for a specific event.1 We adopt these postulates in part and outline a method
for calculating discrete and continuous probabilities of an assets change in price
using only physical analogs.
This theory is testable in part. The probability of an assets price displace-
ment can be currently assessed by observing the occurrence of certain price
displacements using a very large historical price sample for specific financial
assets and comparing the predictions of the theory with the true probabilities
occurring in the stock market.2 We attempt this comparison with only two
assets in Appendix A to this paper. These limited results show that the proba-
bilities predicted by the theorys equations are within 0.02 points (2 percentage
points) of the probabilities calculated from over 11 years of historical data.
Although some might dismiss out of hand the possibility of this theory by
stating flatly that economics is not physics,3 there seems to be little that would
restrict analyzing a system representing the information generated by human
interactions simply because the object of that system happens to be the specific
category of human interaction. While it is true that at the individual level it
might be impossible (or at least extremely complex) to express the personal
decisions and actions of an individual human person in mathematical terms and
relations, much of this individuality is lost in the aggregate; especially when the
magnitude of the aggregate is regularly in the millions or even billions.4
One might expect to simply apply the standard equations of physical motion
to arrive at our conclusion, but this proves not possible.5 We must accept the
fact that certain modifications must be made in order to ensure our results
match experience. These modifications are not blind leaps of faith, but they
are not direct derivations either. Although we will certainly adopt quite a few
physical equations, our primary concern is to adopt the ideas of physical motion
as they might apply to the price movement of financial assets. Perhaps then
economics is not physics, but that is not to say that it is impossible for the two
to be very closely related variants of each other, especially on the macro-level.
We must also be clear as to the limits of this paper. What does this frame-
2 In this way, our use of the term probability is consistent with the frequentist interpre-
III (1942)(Economics deals with human action, not with objects (as physics does)....)
(emphasis in original).
4 Ive written previously on this topic in the limited context of tax compliance. Here I
expand the notion to other human interactive systems. See J. T. Manhire, Tax Compliance
as a Wicked System, 18 Fla. Tax Rev. 235 (2016); J. T. Manhire, Deriving the Expected
Value of the Tax Underreporting Rate 2 J. Poly & Complex Sys. 4 (2015); J. T. Manhire,
There Is No Spoon: Reconsidering the Tax Compliance Puzzle, 17 Fla. Tax Rev. 623, 257-
61 (2015) J. Manhire, Toward a Perspective-Dependent Theory of Audit Probability for Tax
Compliance Models, 33 Va. Tax Rev. 629 (2014). Others have written about the unity of
ecosystems and how small-scale and large-scale dynamics support and affect each other. See,
e.g., James H. Bunn, The Natural Law of Cycles: Governing the Mobile Symmetries
of Animals and Machines (2014). We see a similar issue with the statistical mechanics
of Brownian motion. See Albert Einstein, Uber die von der molekularkinetischen Theorie
der W arme geforderte Bewegung von in ruhenden Fl ussigkeiten suspendierten Teilchen, 17
Annalen der Physik 549 (1905).
5 Although others have certainly tried. See, e.g., Belal E. Baaquie, A Path Integral Ap-
proach to Option Pricing with Stochastic Volatility: Some Exact Results, 7 J. Phys. I France
1733 (1997).
work mean for our understanding of the true nature of financial assets and their
movements? This theory provides no explanation for these phenomena. By the
end of this paper, the reader will know no better what an asset really is, other
than a system of information. The paper merely provides a new theory for
measuring one aspect of our experience; a construct that hopefully surmounts
earlier contradictions between economics and physics.
As a consequence, the theory reported in the following pages might very
well be wrong,6 although the very close match between the predicted and ac-
tual probabilities suggests there is something here worth investigating. Even if
parts end up being incorrect, there is still value in looking at something from a
completely different angle and explaining it in a fresh way. As Richard Feynman
wrote in his own work on the principle of least action, there is always the hope
that the new point of view will inspire an idea for the modification of present
theories.7
The paper begins with an examination of how prices move for financial assets
traded on an exchange and concludes such is an analog to harmonic oscillation.
It then turns to constructing probabilities for specific price movements of an
asset using the Lagrangian method and its principle of stationary action. Lastly,
it combines the probability computations for price displacement magnitude and
direction to formulate a single method of predicting the probability for a specific
price displacement in a specific direction.
6 In which case this paper will end up as just one more attempt to accomplish the pa-
about the degree to which the asset as a system of information complies with
physical laws.
The chart in Figure 1 shows the SPDR Dow Jones Industrial Average (Ticker
Symbol: DIA) for one week of trading. The time axis t is the abscissa and the
price axis x is the ordinate.
Lets call the state of this asset at the very beginning of this one-week period
A = (tA , xA ), meaning that before the opening bell rings for this week, the asset
starts at price xA . Well define the very end of this same one-week period as
B = (tB , xB ), meaning that the moment after the bell rings to end this week
of trading the asset is at price xB . For the sake of brevity, lets call the elapsed
time simply t and the change in price simply x. In other words, tB tA = t = t
and xB xA = x = x, unless specified otherwise.
We are concerned here only with the price displacement x and less concerned
about the actual values of xA and xB . For this reason, we can assume xA = 0
for any discussion of the price displacement as such. This is because the change
in price is homogeneous even if prices themselves are heterogeneous. There
is a difference between $100 and $20, but no difference between $100 minus
$95 and $20 minus $15. In both cases x = $5. The same can be said of any
elapsed time t, allowing us to assume that tA = 0. This is a version of a passive
coordinate transformation that is allowable since the changes in price and time
are homogeneous, or invariant under translation. This assumption also means
changes in price and time are isotropic, or invariant under rotation.
From Figure 1 we are tempted to see the assets price movement from xA
to xB as a path that it takes through various prices from tA to tB . Indeed, we
will call this the particles price path later in our discussion, but for now to
view the fundamental dynamics of the system as a path through time can be
misleading. The path is the end result of a much more basic dynamic.
To examine this more fundamental price movement, we need to divide the
time axis into infinitesimal slices and see whats happening at each slice. For
the movement of the asset from state A to state B along the price path, we can
define a time sequence of
We can make n quite large, which will divide this sequence into n + 1 infinites-
imally small segments of = (tB tA )/(n + 1). In the limit as n , these
time segments approximate a continuous change in time.
The first question is then, whats happening at each time segment ? The
dynamics are quite simple. The asset is doing one of three things at any time
slice. It is either moving up in price, down in price, or there is no change in
price. Thats it. There is nothing more this system does at each moment than
move up, down, or maintain its price. Everything else is just a scalar of this
movement.
The second question becomes, what makes the asset move up, down, or not
at all in price? We assume as a postulate for this discussion that the assets
change in price, even if that change is zero, is determined by only two types
of external forces acting upon the asset. To generalize, we will call the source
of the force that pushes the asset up in price Buyers and denote the source
generally as U . Likewise, we will call the source of the force that pushes the
asset down in price Sellers and denote this source as D. This theory holds
that there are no other external forces that affect the assets price movement.9
The third question becomes, what are the dynamics of how these sources
affect price movements? The answer to this third question will consume the
remainder of this section.
physics: Correlations and Complexity in Finance 8 (2000) (Financial markets are sys-
tems in which a large number of traders interact with one another and react to external
information in order to determine the best price for a given item.).
d2
sin x = sin x (2)
dx2
and
d2
cos x = cos x. (3)
dx2
This suggests that our equation of motion might take a similar form. If we carry
forward our assumption that F ( ) x( ), we can conjecture that
d2
m [x( )] = k[x( )], (4)
d 2
where k is some constant of the system that is directly proportional to its mass.
The brackets are just to highlight the original price displacement function. Note
that the right-hand side of equation (4) is the price displacement and the left-
hand side is the force acting upon the asset. Therefore, we obtain a possible
expression for our assumption that F ( ) x( ).
10 It is likely more proper to call this mass a density since it ends up measuring the mass
per unit volume. However, since we are dealing only in the single dimension of price, the mass
per unit volume is really just the mass per unit length of the price displacement x. Assuming
that price is measured in units of position where the unit price displacement is xunit = 1.00
point, then m/xunit = m. Therefore, it is appropriate to simply refer to this scalar as m.
Equation (4) describes the motion at a discrete time slice and is, therefore,
time-independent. But we know from Figure 1 (and experience) that prices
move forward in time, specifically here the elapsed time tA to tB . Therefore,
we must modify equation (4) to reflect the fact that price displacements are
ultimately time functions. With this modification, equation (4) becomes
d2 x(t)
m = kx(t). (5)
dt2
This second-order linear differential equation is that of a harmonic oscillator.11
d2 x(t) dx(t)
m = kx(t) (6)
dt2 dt
where dx(t)/dt v. This additional term is an analog to the dampening term in
a dampened harmonic oscillator. We can re-write this with the terms associated
11 For simplicity, assume going froward that the price displacement is always a function of
time unless otherwise specified; i.e., xj xj (t), j {U, D}, where xj is to be read as the
price displacement in the j direction.
12 It is possible to imagine p as a free particle that moves in a constant, zero potential. As
we shall see, we can most likely arrive at similar results for the probability of price displace-
ments if we assume p is a free particle; however, this description does not appear correct. Lets
imagine that p moves in price as a result of external forces acting upon the asset. If the forces
generated by U and D toss p back and forth like a ping pong ball, there would be a moment
at the closing bell when the volley would stop and whoever got the last hit ineither U or
Dwould give p the push necessary to maintain a constant, uniform velocity and continue
moving in price until the next opening bell when the opposite source gets a chance to hit it
back. In the interim, p would continue to drift with a constant, uniform velocity per Newtons
first law. But we dont see this drift. At the closing bell, trading stops and so do any changes
in price that are not a result of some after-market interference (correction). The particle does
not drift, but stops. When the next opening bell rings, the opening price, which is simply
the price as a result of the first trade, might be different than the previous closing price, but
this is due to U and Ds interactions at that moment, not due to a residual drift from the
previous interaction. For these reasons, we hold that it would be incorrect to regard p as a
free particle.
with acceleration, velocity, and displacement all on the same side to get
d2 x(t) dx(t)
m 2
+ + kx(t) = 0. (7)
dt dt
To simplify notation and save space going forward, we will use Newtons
dot notation when possible indicating a time derivative. Accordingly, x x
2
(displacement), x dx ddt2x (acceleration).
dt (velocity), and x
m
x + x + kx = F (t). (8)
This way we have more than just the two special cases of no external forces or
balanced external forces. Equation (8) allows us to now explore the dynamics
of unbalanced external forces.
An external force need not come from the same source. In fact, F (t) in
equation (8) is the net external force and, therefore, is the the sum of all the
forces acting upon the asset at any time slice . The theory posited here holds
that the force generated by activities of Buyers U at a time slice creates a
positive price displacement, and the force generated by activities of Sellers D
creates a negative price displacement. It is the sum of these forcesthe sum
of all the forces, not just those generated by some discrete U and Dthat is
responsible for an assets price displacement.
We can begin to think about this more formally by imagining a net external
force over some time slice that is the result of a single pulse from U s activities
and a single pulse from Ds. Lets call this a pulse pair. U and D are not
taking turns interacting with the asset, but are doing so together even though
each source might be exerting forces that do not balance with the other. The
benefit to this approach is that if we can figure out the assets price response
to a single pair of opposing pulses, then we can find the response to millions
and even billions of these pulses by simply summing the single pairs of opposing
pulses.
We can set up our initial pulse pair quite easily. Imagine that xU is a
time-dependent price displacement resulting from the force FU generated by U .
Likewise, xD results from force FD generated by D.13 From equation (8) we see
that the net force generated by U becomes
m
xU + x U + kxU = FU , (9)
m
xD x D kxD = FD . (10)
[m xD x D kxD ]
xU + x U + kxU ] + [m
d2 [xU xD ] d[xU xD ]
=m + + k[xU xD ] (11)
dt2 dt
= FU FD .
Therefore, we see that the net external force F = FU FD produces the price
displacement x = xU xD . Of course, this is equivalent to F = FU + (FD )
and x = xU + (xD ). This essentially gives us a superposition of solutions
that continues as we add up more and more pulse pairs. If we think of the
time-dependent net external force as the sum of pulses over the interval t, then
the price displacement x will be the sum of all responses to the individual pulse
pairs. Note that we have succeeded in creating an ostensibly arbitrary function
F (t) out of multiple pulse pairs.
We can accomplish a similar feat by generating an arbitrary function out of
sine and cosine waves. In other words, the force pulses generated by U and D
can amount to a collection of sine and cosine waves generating pulses in slices
of time through constructive interference. This idea is at the heart of Fourier
analysis and is basically a Dirac delta function. It is what represents the mass
of the idealized point particle p discussed in 2.2 previously.14
Specifically, we are looking to describe a system that is driven only by an
external force where that force depends on time as before, only now it depends
on time as a cosine or sine function at an angular frequency , which is the
wave frequency multiplied by 2 radians (one rotation around the unit circle).
Since sine and cosine functions are essentially the same functions with the only
difference being how we define our initial condition tA , we can assign the cosine
function to represent the interactions of U with the asset, and the sine function
to represent the interactions of D with the asset. This is an arbitrary assignment
and it can just as easily be made the other way around. As we shall see, these
13 Assume all forces are functions of time. For simplicity, F F (t) unless specified other-
j j
wise. F0 indicates the critical point of the pulse pair, and F0 = F .
14 See George B. Arfken & Hans J. Weber, Mathematical Methods for Physicists
84 (5th ed., 2000). Again, this is more accurately called the linear mass density of p, but we
shall stick with mass for reasons already discussed.
assignments will not alter our resultant force. U is the wave generated by U s
trading activities and D is the wave generated by Ds trading activities. As a
result, we get
U = m xU + x U + kxU = F cos(t), (12)
and
D = m
xD + x D + kxD = F sin(t). (13)
Recall that the net external force is a sum of the pulse pair constituents,
so we next must add equations (12) and (13) together. We can combine these
equations by multiplying equation (13) by i = 1 and then taking the sum of
equations (12) and (13). Doing this yields
d2 [xU + ixD ] d[xU + ixD ]
m + + k[xU + ixD ] = F [cos(t) + i sin(t)]. (14)
dt2 dt
Expressed as waves, this becomes = U + iD where is a complex function
of time.
Since, in general, any complex number z can be expressed in the complex
plane with the real- and imaginary-axes < and = as
where is the angle between z and the <-axis, it is plausible to regard the
right-hand side of equation (14) as an expression where the net force is the
magnitude of a complex force function, and the angle = t is the frequency
over time in radians. This produces = |F |[cos(t) + i sin(t)].
As a result, we next make two minor modifications. The first is to recognize
that xU + ixD is actually a single, complex, time-dependent function that well
call (t). The second is to recall that, per Eulers formula, cos(t) + i sin(t) =
eit , where e = limn (1 + 1/n)n . We can, therefore, re-write equation (14) as
+ (t)
= m(t) + k(t) = |F |eit . (16)
we find that
= Aet
(t) (18)
and
= 2 Aet ,
(t) (19)
where A is the complex amplitude of the complex wave function . Substituting
these results into equation (16) we get
Figure 2: = |F |[cos(t) + i sin(t)]. The dotted curve is the real cosine function, the dashed
curve is the imaginary sine function, and the solid curve is the complex resultant wave that
is a superposition of the cosine and sine functions. The complex amplitude A is proportional
to the net force. In this Figure, |F |= 1.
Since the terms in parentheses are independent of time, we must conclude that
= i so that the two sides are equal at all times. This means the complex
displacement function (t) has to have the same angular frequency as the
net external force F . From this we can conclude that if a pulse pair (FU , FD )
generates the net sinusoidal force F and angular frequency , the assets price
displacement x will vary as a time-dependent sine or cosine function of the
same angular frequency . We should expect this since the original equation of
motion in equation (5) is linear.
Because = i, we can consolidate equation (21) further
Thus, the external force in terms of the complex amplitude and mass-related
terms becomes
(m 2 + i + k)A = F. (23)
If the angular frequency of the net external force is the same as the angular
frequency of the asset (and this might not always be so), then m 2 = k. In this
case, the terms would cancel leaving
F = (i)A. (24)
A = |A|ei , (25)
where is the phase shift in the complex plane relative to the net external force.
The complex phase shift is then
=-axis |A|sin(t)
= arctan = arctan = arctan[tan(t)]. (26)
<-axis |A|cos(t)
Therefore,
x(t) = |A|cos(t + ). (28)
In other words, the price displacement is a cosine function of time and angular
frequency with an amplitude |A| and a phase shift . From this we can conclude
the following about the direction of x(t) based on the angular frequency, elapsed
15 We do not attempt here to explain the nature of such a dampening term, only its function.
(t + ) = 2
0
(t + ) = 3
0
x(t) 2 (29)
3 5
+
2 < (t + ) < 2
3
2 < (t + ) < 2
If we seek to make the price displacement independent of time (i.e., the price
displacement at the arbitrarily-small time slice ), we can set t = 0 to remove
the temporal term. This leaves us with
x( ) = |A|cos . (30)
or
|x( )|= |A( )|. (32)
In other words, the magnitude of the price displacement at each time slice
is the magnitude of the resulting pulse waves amplitude at that time slice.
Recall that the relationship between |A| and the net external force at the same
time slice is dependent on the value of , which in turn is proportional to
the mass of the asset and its velocity.16 We can reasonably assume, therefore,
that our resultant probability calculation must be some function of mass, price
displacement magnitude, and velocity. Having derived the price displacements
modulus at each time slice in equation (32), we next turn to our probability
investigation.
16 It is an interesting observation that the up and down motion of prices can also be described
as a Tusi couple. Imagine a unit circle in the complex plane, only reverse the normal convention
and make the abscissa the imaginary axis and the ordinate the real axis (i.e., rotate it a quarter
turn counterclockwise). Inside this unit circle, construct another circle of 1/2 radius that rolls
clockwise along the internal circumference of the unit circle. The point of contact between the
circles is ei and the center of the interior circle is ei /2. If we trace the point where the two
circles connect when starting the roll at the top we see that this point moves in a straight
line from the top to the bottom and back again as the smaller circle makes its rotation inside
the unit circle. This is the exact real motion of the asset we described as a harmonic oscillator.
Tracking this motion we see that
ei ei() ei + ei
= = cos = <(ei ),
2 2 2
just as we derived in equation (27). Its interesting to think of an assets linear price movement
as potentially being the result of some grander circular motion.
3. Probabilities
If we look at the same waves, still with a phase shift = 0, but this time when
both are at the waves minimum amplitude, we find that FD is at its strongest
and FU is at its weakest. Since the price displacement is a function of the net
external force, we should expect a negative price displacement. The probability
of getting a negative price displacement again comes from equation (33)
0
Pr(xD ) = cos2 = cos2 (0) = 1, (35)
2
Therefore, the probability that the price displacement will be in the up direction
is 0.50, or 50%. The probability that the price displacement will be in the down
direction is also 0.50, since Pr(xD ) = 1 Pr(xU ) in all but the extreme case we
will examine next.
If = , then both the positive and the negative price forces are at their
strongest and these forces balance (cancel each other out).
Pr(xU ) = Pr(xD ) = cos2 = 02 = 0, (37)
2
meaning there is no probability that there will be any price displacement.
Note that this probability measure does not tell us the magnitude of the
price displacement, only the probability that the displacement will be either
positive or negative, with a zero probability of either occurring in the special
case when = .
So we see that we can compute probabilities from cosine waves, which means
we should also be able to compute probabilities from sine waves just as easily
since both functions have the same hidden information within them. Of course,
we will need to look at more than just the phase shift if we want to find the
probabilities of specific price displacements and not merely whether they will
be positive or negative. To do this, we return to the dynamics responsible for
any price displacement: the pulse pairs generated by U and Ds activities in the
form of sine and cosine waves.
find the total number of balls in the bin we summed over all the balls and got
10. We then divided the number of blue balls, 4, by the sum of all balls, 10,
and got our answer. The sum over all the balls acted as a normalizing factor
in calculating the correct probability. This way any probability calculation we
make concerning the 10 balls in the bin will be between 0 and 1, which puts us
in compliance with the principle of unitarity. If we had said the probability of
selecting a blue ball was just 4 without the normalizing factor, we would have
been wildly inaccurate.18
The same is true for normalizing the Gaussian in equation (39). We need
to divide by an equation that gives us a sum of all possible results to get a
normalized probability measure.
1
Figure 3: Plot of Gaussian Function; |A|= 1, xA = 0, and = .
2
If we look at a graph of equation (39) we see that all results on the probability
axis (the ordinate) are positive regardless of whether the input is positive or
negative. The exponent is a parameter that is proportional to the price
displacement. A price displacement can be either positive or negative depending
on whether the assets price ends up higher or lower than its previous closing
price. This means the exponent can take on all values from negative to positive
infinity and still produce a positive probability measure that is no greater than
unity as long as the amplitude factor is a maximum at unity. Consequently, we
can take our first step towards deriving our normalizing term by taking the sum
of all possible values for x, both positive and negative.
As in the balls and bins hypothetical, we divide the main term by the nor-
malizing term to maintain unitarity. For balls and bins, the sum of all balls
was 10. We can either divide 4 by 10, or simply multiply 4 by 101 , which is
the same as multiplying by 1/10. Generalized, this means we must give our
normalizing term the exponent 1.
18 Admittedly, normalizing terms can be a bit more complicated than this simple example
of bins and balls, so the analogy might fail after a certain point. But it helps to give us
an intuition for what we are trying to accomplish with a normalizing term when we want our
end result to be a probability measure with a value in the range [0, 1].
Just as the normalizing term for balls and bins was the sum of all balls in the
bin, the normalizing term for our generalized equation for the discrete probabil-
ity of the price displacement equaling X is the sum of all price displacements in
the Gaussian. Since the Gaussian is continuous, we integrate instead of taking
a sum of discrete parts. Taking the integral over all possible price displacement
values in the Gaussian means integrating from to +. The result is the
normalizing factor
+ 1
x2
Z
1
Q= exp 2 dx = . (40)
2 2 2
2
Recall from equation (39) that for e , the standard deviation is = 1/ 2.
Substituting this value of into equation (40) gives the normalizing term
1
Q= . (41)
2
Equation (41) gives us only the proportionate normalizing term. The final term
must also account for any constants or other terms that are not a function of
the price displacement. To be clear, we now have a generalized Gaussian as a
result of the generalized waves U and D , but we must modify this generalized
Gaussian so that it matches specific characteristics of specific assets, for the
probability of the financial asset p1 experiencing the price displacement x is not
necessarily the same as the financial asset p2 experiencing the same.
If we consider what U and D contribute to an asset, we must conclude at
the most general level that they contribute to the total energy in the asset.
There is no evidence that the asset has its own inherent energy, at least not in
the sense that the asset can move in price on its own. In fact, we often see
lightly-traded assets experiencing no price change for relatively long periods of
time. Why is this? Because either (1) U and D are in phase shift = and
the forces cancel each other out; or (2) there are no buyers or sellers interested
in trading the asset for that interval. Without buyers and/or sellers, the asset
does not experience a change in price. Thus, there is nothing inherent to the
asset that can contribute to the change in its price.
Considered this way, we can conclude that the pulse pairs of U and D con-
tribute potential energy V into the system through the superpositon of U and
D . This potential energy causes work to be done on the asset, which results in
its change in price. Through this process, the potential energy V is transformed
into kinetic energy K. But once V = 0 (i.e., no interaction between U and
D), there can be no further price movement without additional introductions of
potential energy into the system through the interactions of U and D. We can,
therefore, conclude that U and D are the sole sources of the total energy E in
the system at any time slice . The total energy at is never more than the
measure of V .
This tells us a lot about the amount of energy in the asset at any single time
slice. Since the only energy is potential and all potential is converted to kinetic
energy, we can conclude that the total average potential energy and the total
average kinetic energy are the same.
The kinetic energy in a system is defined as
1 mx2
mv 2 = . (42)
2 2t2
It is easy to see that the kinetic energy at the time slice is the sum of all the
net forces over the price displacement x( ), since
mx( )2
Z
mx( ) m
x( ) F
= (x U ( ) x D ( )) = x( ) = x( ) = F dx( ), (43)
2 2 2 2 2 2
where the far left-hand side is the kinetic term and the far right-hand side is
the potential term (sum of the external forces over the change in price).
Since there is no trading immediately before the opening of an exchange,
|FU |= |FD |= 0. The kinetic energy K0 is equal to zero since there is no price
movement. As trading commences, U and D engage in the trading activities that
generate the forces FU and FD , which combine to form the net external force
F . This net force is the catalyst for movement in price as long as |FU |6= |FD |.
At the end of the days session trading ceases. There are no external forces
and, therefore, no work to produce the kinetic energy from price movement.
From this we can state that the total energy in the system at any one time
is the potential energy, which is fixed and equal to the measure of the kinetic
energy. But what is that measure?
The equation for kinetic energy of a harmonic oscillator is found in equation
(42), and the equation for the potential energy is
m 2 x2
V = . (44)
2
The price displacement from equation (30) is x( ) = |A|cos . Since the velocity
v is equivalent to the first derivative of x, we see that v( ) = |A|sin . We
can modify equations (42) and (44) accordingly:
mv 2 m 2 m
K( ) = = (|A|sin ) = |A|2 2 sin2 , (45)
2 2 2
and
m 2 x2 m 2 m
V ( ) = = (|A| cos ) = |A|2 2 cos2 . (46)
2 2 2
The total energy is the sum of the potential and kinetic energies, or E = K + V .
Adding the two previous equation together yields
m 2 2 2 m m
E( ) = |A| sin + |A|2 2 cos2 = |A|2 2 (cos2 + sin2 ). (47)
2 2 2
Recall the trigonometric identity, cos2 + sin2 = 1. Therefore,
1
E( ) = m 2 |A|2 . (48)
2
m 2 |A|2 m 2 |A|2 2
mvmax
E[K( )] = E[sin2 ] = = (51)
2 4 4
and
m 2 |A|2 m 2 |A|2 2
mvmax
E[V ( )] = E[cos2 ] = = . (52)
2 4 4
This shows that, on average, the kinetic and potential energies of the asset are
the same, each being exactly one half the total energy of the oscillating system.
The total energy density of is then
2
mvmax mv 2
E[E( )] = E[K( )] + E[V ( )] = . (53)
2 2
If we think through the source of this energy from equation (53), we again
confront the fact that it only comes about as a result of the activities of U and
D interacting with the asset. The potential energy is ontologically prior to the
kinetic energy. We can, therefore, conclude that the best description of the asset
19 We have to choose one or the other. If we define the kinetic and potential energies by
their 1/4 averages in equations (51) and (52), the Lagrangian L = K V becomes zero. As
we shall see from Schr odingers work, choosing the potential makes the most sense.
20 Hamiltons principle asserts that physical trajectories are paths between x and x , which
A B
are critical points of the action. William R. Hamilton, First Essay on On a General Method
in Dynamics, Philosophical Transaction of the Royal Society 95 (1835); William R.
Hamilton, Second Essay on On a General Method in Dynamics, Philosophical Transaction
of the Royal Society 247 (1835).
21 Paul A. M. Dirac, The Lagrangian in Quantum Mechanics, 3 Physikalische Zeitschrift
{1, 2, , n}, sometime before reaching xB , there is no way the asset knows
that its destination is xB . Therefore, the stationary action, meaning the first
variation S = 0, cannot be in any sense global. Any global application must
instead be a sum of all the local stationary contributions along the way at each
intermediate state (tN , xN ). The asset travels the total path one stationary
segment at a time. This is why the path for the asset DIA in Figure 1 is not
simply a straight line from the beginning to the end of the week, but is rather
a collection of smaller price movements x( ) that are each themselves critical
points of the functional S[x].
Substituting equation (54) into (55) we get
tB
mx2 mx2
Z
S[x] = 2
dt = . (56)
tA 2t 2t
This conclusion is consistent with the findings of others regarding the La-
grangian. First, the action as a physical quantity has the dimensions [energy]
[time], which breaks down to dimensions of [mass] [distance]2 [time]1 . These
dimensions are consistent with the result in (56). Second, Erwin Schrodinger
points out the following as a well-known principle:22
S[x]
= mv. (57)
x
Schr odingers reference implies that the changes in the price displacement ele-
ments of the action constitute the momentum of the asset in configuration space
at any elapsed time t. In other words, a small change in the action is equivalent
to the quantity of the assets motion over any small change in price. So if we
add up all of the quantity of motion over the total price change from xA to xB
(i.e., the sum of all the changes in price along the path from xA to xB ), we
should get the total action for that price displacement. Integrating both sides
of equation (57) with respect to x gives us
mx2
S[x] = .
2t
From equation (56) we see that
tB
mx2
Z
S[x] = = L(x, v) dt.
2t tA
mx2
L(x, v) = , (58)
2t2
22 E. Schr
odinger, An Undulatory Theory of the Mechanics of Atoms and Molecules, 28
Phys. Rev. 1049, 1052 (1926).
which is identical to what we see in equation (54) for the Lagrangian of the
asset. It appears, therefore, that the Lagrangian is equivalent to the potential
energy introduced externally from U and D, and thus is a function quadratic in
velocity.
Since our primary goal is to find a way to measure the probability of assets
price displacement, we must look to a measure of the systems energy that
is proportional to its price displacement over the interval t. We find such a
measure in equation (56). We can assume the mass of the asset is sufficiently
fixed for our purposes and although t is variable, we are only looking for the price
displacement over a fixed time duration, which means we can hold t constant.
Both the mass and the time interval are elements of the action, and the only
remaining variable is the square of the price displacement, or x2 , which is what
we assumed 2 is proportional to at the beginning of 2.2. Given that the price
displacement is squared, we will be limited to predicting only the magnitude of
the price displacement and not whether it is in the positive or negative direction.
Accepting this limitation, we conjecture that 2 S. Substituting this into
equation (39) gives us eS .
This approach is quite similar to that taken by Paul Dirac and Richard
Feynman in introducing the Lagrangian into quantum mechanics with the form
eiS/h .23 In natural units, h = 1, thus making the primary difference that in
the theory
espoused here, the equation for the superposition of the pulse pairs
is ei S , while for quantum mechanics its analog is eiS . This implies that the
superposition of the pulse pair for each asset is, again, the addition of the
pulse
from U and the pulse from D, although more specifically t = S, or
( S) = cos( S) + i sin( S).24 Note that in this section |F | and |A| both
equal unity. From equation (24), this implies that at least for our probability
calculations, the dampening term i must also equal unity if m 2 = k. This
further implies that 2 = t2 and k = m/t2 .
Substituting 2 S into the proportionate normalizing term in equation
(41) and taking the product of the two terms becomes
eS m
r
QeS = . (59)
2 t
Note also that the proportionate normalizing term in equation (41) is strik-
ingly similar to the normalizing term for the Feynman path integral derived by
Jun Sakurai. The proportionate normalizing term here in terms of the action
becomes r
m
Q= , (60)
4t
25 See J. J. Sakurai & Jim Napolitano, Modern Quantum Mechanics 118 at Eq. (2.6.16)
or more simply
erfc(|xN |) = 1 erf(|xN |). (65)
Because of the principle of unitarity, we can only find the probability of the
magnitude of the price displacement |x| being less or greater than X. This is
because the error function and its complement only return positive probability
values for non-negative price displacement values.
Of course, what we just finished describing are the probability calculations
given price displacements that are normally distributed about the mean = 0.
In order for us to use this tool to make our probability predictions concerning
a specific financial asset, we must remember to normalize that asset as we did
with discrete probabilities since the probabilities of the same price displacement
are unique for each financial asset. Whats more, we will also have to square
the normalized result in order for our predictions to match historical data just
as we did with discrete probabilities.
Fortunately, taking the integral of the Gaussian function yields the error
function, but we must still normalize the result as before. Unlike with the
discrete case where we normalized by dividing by the integral from to +,
we must normalize here with an integral from 0 to +. This is because, as just
discussed, we are restricted to non-negative values as evidenced by the ranges
in equations (63) and (64). Using the same approach to normalize as we did in
equation (40) and squaring the results we get
R x S !2 r 2
e dx m
Pr(|x|< X) = R S0
= erf |x| = erf( S)2 , (66)
0
e dx 2t
and
R S !2 r 2
e dx m
Pr(|x| X) = x
R
S
= erfc |x| = erfc( S)2 . (67)
0
e dx 2t
Accordingly, equations (62), (66), and (67) give us the proper methods for
calculating the probabilities associated with any financial asset in terms of its
action.
5. Conclusion
It is possible to test this theory using, say, weekly historical data for an asset,
in which case |x| is the difference in points between the closing price at the end
of a weekly interval and the closing price at the end of the immediately-previous
weekly interval, t = 5 days, and m (without units) can be approximated from a
relatively small sample s of the assets weekly intervals using the equation
p 2
1
s
1 X 2t erfc Pr(|xN | XN )
E[m] = . (74)
s q=1 |xN |
Taking 11 years of historical data for two major ETF Indices, DIA (already
mentioned) and SPDER S&P 500 (ticker symbol: SPY), one can verify this
theory at least to a limited extent. A quick sampling of historical weekly data
employing equation (74) yields m = 0.2458 for DIA and m = 0.2069 for SPY.
Calculating the probability of a price displacements magnitude using only equa-
tion (64) for each week over the 11-year period produces a maximum error of
only 0.02.
One also sees that the mean magnitude of the price displacement for an
asset with a higher mass such as DIA (m = 0.2458, E[|x|] = 2.15 points) is
less than the same measure for an asset with a lower mass such as SPY (m =
0.2069, E[|x|] = 2.38 points). This is consistent with the theory since a larger
mass should result in the probability of the asset having a price displacement
of zero being higher than an asset with a lower mass. This is also supported by
Appendix A.
The following tables assume a statistically constant value for weekly elapsed
time of t = 5 days and a statistically constant value for mass, the units of which
we assume exist but as of yet do not know what to call.