Chollada Tontanasutthivong (Frame)

Group 3
2nd draft on 29 August 2016

How to deal with unpredictable stock market

A stock market is a public market in which stock brokers and traders can buy and sell stocks.
It is called a secondary market because it involves trading between two investors. Prices are
set depending on supply and demand. If stocks are in demand, stocks can increase their price
but if they are being sold significantly, stocks can decrease their value (Mayankkumar &
Sunil, 2014). In todays world, numbers of money are traded through the stock market around
the world. For example, from statistic of the wall street journal shows that The New York
Stock Exchange (NYSE) have total averaging around US$152 billion in weekly trading

value between August 19, 2016 and August 26, 2016 (Markets Diary: Closing Snapshot,
2016). There are strong connections between national economics, and influences the
performance of the stock market. Recently, the stock markets are more accessible, not only
for strategic investors but also for general people (Efstathios, 2001).

The Taiwan Stock Market has become one of the most interesting emerging stock markets in
the world because there is an dramatic increase in international investors' transactions in
several years and their trading volume has annually jumped from NT$265 billion in 1994 to
NT$4,366 billion in 2003 (Yi-Chein Chiang, & Chih-Chen, K, 2006). Recently, the economic
liberalization in Taiwan has attracted numerous and varied investors that increase both many
participants and trading volume in the market. According to the statistics of the Taiwan Stock
Exchange Co. (TSEC), between 2000 and 2008, local private investors held an average of
74.99% of the total capitalization of the Taiwan Stock Market. It can be seen that individual
investors dominate the Taiwan Stock Market (Shu-Yu & Huang-Ming, 2011). Taiwanese
investors, however, usually get losses as they lack knowledge of a stock market, make under-
informed investments to predict the stock market. (Tsai & Wang, 2009).

This essay intends to present techniques to assist Taiwanese investors in making accurate
decisions. It is important to Taiwanese investors in the Taiwan Stock Market, and also other
countries. Also, in this essay, I would argue that although technical technique is useful, a
hybrid learning machine technique is more useful for investors.

Lack of knowledge of the stock market can be found in many countries. For instance, from
2000 British people, the survey was found that 87% of respondents could afford to invest, but
around 74% lack the stocks market knowledge (Brenchley, 2016). According to a survey
study by Natixis Global Asset Management of the United Arab Emirates (UAE),

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approximately 80% of UAE investors acknowledged that they lack a strong knowledge of
investment (Sophia, 2013). Under-informed investment is one of the main problems of
private investors in many countries, including Taiwan. Thus, understanding investment is the
principal factor to give increased returns. It can be supposed that when there is an increase in
the level of knowledge, investors will obtain maximum utility (Cianci & Kaplan, 2008). Tsai
and Wang (2009) confirm that if investors have knowledge of the stock investment and know
how to predict a stock market, investors will invest with confidence.

A stock price prediction plays a significant role in the investment market because it points out
the desirable or undesirable investment of investors and stockholders. If the decisions made
always be right and if we can predict the stock price for the following day, week or even a
month, many investors would become instant millionaires. This fact motivates many
mathematicians and investors to respond to the question how the stock market can be
forecasted. Using the knowledge they received from mathematics subjects such as Calculus I-
IV, Linear Algebra, Statistics, and mathematical algorithms can help many investors to
predict a stock market (Wojtak, 2007). Due to investors having to deal with uncertain and
deficient data which rapidly fluctuates over a short term period, there are some solutions to
help them deal with and these solutions have both benefits and drawback.

First of all, using technical analysis, technical analysis is a study of the past trends of a stock
market and historical price fluctuations. Technical analysis practitioners use price charts and
price data to predict future movements (Turner, 2007). The Figure 1 below shows the price
chart which the vertical axis shows the price and the horizontal axis shows the time (Pottorff,
2016).

Figure 1. EUROUSD Spot EUR USD Spot 1.4505 (+0.00%) Daily

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There are different kinds of the price charts such as line charts, and candlestick charts which
these charts are very common used.

Pottorff (2014) argues that the most common chart and the most popular chart are candle
chart. Technical analysis has come from the theories of Charles Henry Dow who is co-
founder of the Dow Jones and the founder of the Wall Street Journal (Kristopher, 2014).
There are six steps that can help investors understanding technical analysis, and applying to
choose stocks and commodities. The first step is that investors have to understand Dow's
theories. The theories describe three things; market fluctuations response to all information,
predictions from price movements, and the fact that history repeats itself. Focusing on quick
results that means investors have to look at results on periods which are less than a month,
and read charts and graphs of security prices. Then, they should pay attention to the volume
of trades, and use the price movement average to screen out insignificant price fluctuations.
Finally, they have to practice using indicators or oscillators to calculate the price movements
(Kristopher, 2014). One of the indicators commonly used is called the Stochastic Oscillator.
George Lane developed the Stochastic Oscillator in the 1950s and is used for comparing the
latest closed prices and the high-low price range of any given periods (DAlessio, 2016).
Thus, technical analysis is the first layer which provides a raw data analysis of the price
before applying the second layer based on machine learning techniques (Kristopher, 2014).

Technical analysis technique is the useful not only strategic investors but also general private
investors because it can make investors understand easily by following six steps. It has been
stated that it is a great tool to assist investors in developing investment ideas, and it will be
alert when the stocks change. Moreover, this technique is one of the most useful aspects in
developing quantitative strategies to invest on the stock market (Llanes, 2016).

The other solution is using two kinds of a hybrid machine learning techniques which are an
Artificial Neural Network (ANN) and a Decision Tree (DT). An ANN is used as an essential
model for stock market prediction problems (Tsai & Wang, 2009). According to research by
Chen, Leung, and Daouk (2003), An ANN can be developed in the human brain. Moreover,
an ANN can predict the stock from big data such as price, volatility, correlations, earnings,
volume correctly. However, people cannot comprehend the decision rule in an ANN model
because an ANN does not describe the rules clearly. The other technique is a DT which can

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generate some rules (Wang & Chan, 2006). It is one of the methods for forecasting problems
consisting of nodes and branches which builds classification or regression models in the form
of a tree structure. Every node classifies the output while every branch classifies the process.
After a DT is established, the error rate can be calculated to enhance the forecasting and
classification ability, and make decisions correctly. Compared with ANN, DT can generate
decision rules for analyses.

Research by Tsai and Wang (2009) illustrates the comparison of a hybrid machine learning
technique which is ANN, DT, and ANN+DT to estimate investors forecast performances.
Overall, on average, ANN, DT, and ANN+DT provided prediction accuracy of about 59%,
65%, and 72% respectively. Moreover, the researchers calculate the error methods occurred
from the prediction called as the Type 1 and Type 2 errors which are shown in the table 1
below.

Table 1 Type 1 and Type 2 errors

Prediction
Fall Rise
Fall Type 1
Real
Rise Type 2

The meaning of the Type 1 is that the prediction output is increase, but the stock actually
decrease" while the Type 2 means the prediction output is decrease, but the stock actually
increase.

Tsai & Wang (2009) calculate the Type 1 and Type 2 errors, the table 2 below shows the
prediction performance of an ANN error which provides about 49.5% and 43.7%
respectively. The table 3 below shows a DT error that provides 87.1% and 21.4% errors for
Type 1 and 2 respectively. Combining DT with ANN model shows 71.9% and 1.95% errors
for Type 1 and 2 respectively which is shown in the table 4 below.

Table 2 Type 1 and 2 errors of ANN

Prediction
Fall Rise
Fall 43.7%
Real
Rise 49.5%

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Table 3 Type I and II errors of DT

Prediction
Fall Rise
Fall 87.1%
Real
Rise 21.4%

Table 4 Type 1 and 2 errors of combing DT with ANN

Prediction
Fall Rise
Fall 71.9%
Real
Rise 1.95%

It can be seen clearly that the combining ANN with DT method gets the best average
accuracy in forecasting the stock market, and also performs better for Type 2 errors at 1.95%.
However, it is not satisfying in the Type I error. Thus, for predicting stocks, this model has an
efficiency, but the single model: ANN and DT are not very efficient (Tsai & Wang, 2009).

The combined ANN with DT model is the most effective solution to forecast the stock
market. However, all of these models cannot predict the falling stock market because of low
rates of Type I errors.

Olson and Mossman (2003) confirm that they have all been used to analyse the stock market.
Thus, a combination of both technical analysis and the combined ANN with DT model obtain
better predictions of performances (Tsai & Wang, 2009).

In conclusion, the methods associated with the stock investment prediction were revealed in
the essay. The stock market prediction is actually a challenging task, but both a technical
analysis technique and three models are useful to investors, and can give increased returns.
The former solution is an easy method for public investors to use in the stock prediction more
than the latter because three models might be difficult for general investors to use. Both of
them are very significant for forecasting the stock price.

References:
Brenchley, D. (2016). Potential investors put off by lack of financial knowledge.

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Retrieved on August 16th, 2016 from: http://www.moneyobserver.com/news/25-02-

2016/potential-investors-put-lack-financial-knowledge

Chen A. S, Leung M. T. & Daouk H. (2003). Application of neural networks to an emerging

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Cianci, A.M. & Kaplan, S. (2008). The Effects of Managements Preannouncement Strategies
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DAlessio, G. (2016). Stochastic oscillator definition.

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Larsen, J. I. (2010). Predicting Stock Prices Using Technical Analysis and Machine Learning.
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Llanes, L. (2016). How technical analysis is useful.

Retrieved on August 26th, 2016 from: http://wealthnetinvest.com/how-technical-analysis-is-
useful/

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McLeod, G. (2014). Forex Market Size: A Traders Advantage

Retrieved on August 16th, 2016 from:
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strong-investment-knowledge/#.V7gx5vkrKM8

Tsai, C. F. & Wang, S. P. (2009). Stock price forecasting by hybrid machine learning
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Turner, T. (2007). A Beginners Guide to Day Trading Online. Adams Media, 2nd edition.
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