Learning This Week: Markov Model

Every week I learn something interesting about a topic.

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What is a Markov Model?

A Markov model is a mathematical model used to describe a system that transitions between different states over time, where the probability of moving to the next state depends only on the current state and not on the sequence of past states. This property is known as the Markov property.

Imagine you’re playing a board game. In this game, you move between different squares on the board (these are the states). Where you land next doesn’t depend on where you’ve been before—it only depends on the square you’re on right now. That’s what a Markov model is about: it looks at the "now" to figure out what might happen "next."

Markov Model in Investing

A Markov model can be used in the stock market to help guess where stock prices or market trends might go next based on what’s happening right now, without worrying about how they got there.

You’re watching a stock, and it can be in one of three states:

1. Going up

2. Staying the same

3. Going down

Now, you notice a pattern:

• If the stock is going up today, there’s a 70% chance it keeps going up tomorrow, a 20% chance it stays the same, and a 10% chance it starts going down.

• If it’s staying the same today, there’s a 50% chance it goes up, a 30% chance it stays the same, and a 20% chance it goes down.

• If it’s going down today, there’s a 40% chance it goes up, a 30% chance it stays the same, and a 30% chance it keeps going down.

These percentages are the transition probabilities of the Markov model.

Practical Uses of Markov Model

1. Predicting Trends:
   By looking at the current state of a stock (e.g., "going up"), you can use the probabilities to guess what’s most likely to happen tomorrow. Over time, this helps investors decide when to buy or sell.

2. Market Behavior:
   Markov models can also analyze how different market states (e.g., "bull market" or "bear market") change over time and predict what’s likely to happen next.

3. Risk Management:
   It helps investors understand the chances of a stock entering a "bad" state (like going down) and adjust their portfolios accordingly.

Summary

Stock prices don’t have a perfect pattern—they’re unpredictable and full of ups and downs. But the Markov model can give us a rough idea of what’s likely to happen next, based on what’s happening right now.

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DISCLAIMER:

Investments in the securities market are subject to market risks. Read all the related documents carefully before investing.

SEBI Registered Research Analyst - Cupressus Enterprises Pvt Ltd - INH000013828.

Registration granted by SEBI and certification from NISM in no way guarantee the performance of the intermediary or provide any assurance of returns to investors.