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Backtest Entropy Alpha Strategy with Futures Data Part I
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Stock Market and Probability Distributions

Stock markets do not follow a simple probability distribution like the normal distribution (also known as the Gaussian distribution) that is often assumed in classical statistics. Instead, the price movements of stocks and financial markets are characterized by a more complex and dynamic distribution.

The probability distribution followed by stock markets is typically better described by a fat-tailed distribution. This means that extreme events, such as large price swings or market crashes, occur more frequently than what would be expected in a normal distribution. This characteristic is often referred to as “leptokurtosis” or “kurtosis,” indicating that the tails of the distribution are fatter or have higher peaks than a normal distribution.

Common fat-tailed distributions

When it comes to modeling stock market returns, various probability distributions can be considered, depending on the specific characteristics of the data and the assumptions made. Common fat-tailed distributions used to model financial markets include:

  1. Normal Distribution:
    • Characteristics: The normal distribution, often referred to as the Gaussian distribution, assumes a symmetric, bell-shaped curve with no heavy tails. It implies that extreme events are rare.
    • Applicability: While stock market returns do not strictly follow a normal distribution due to their tendency to exhibit fat tails (more extreme events), the normal distribution is often used as an approximation for daily or monthly returns in certain situations. It is particularly useful when returns are approximately normally distributed over a short period or when modeling changes in returns (returns on returns).
  2. Student’s t-Distribution:
    • Characteristics: The t-distribution is similar to the normal distribution but allows for heavier tails, making it suitable for capturing occasional extreme events.
    • Applicability: The t-distribution is useful when dealing with smaller sample sizes or when estimating parameters such as the mean or variance of stock returns. It provides a more realistic representation of stock market returns than the normal distribution, especially in cases with limited data.
  3. Cauchy Distribution:
    • Characteristics: The Cauchy distribution has extremely heavy tails, meaning it allows for frequent and extreme fluctuations.
    • Applicability: The Cauchy distribution may be used when modeling extreme price movements or “black swan” events in the stock market. However, it is rarely used in practice because it assumes even heavier tails than typically observed.
  4. Log-Normal Distribution:
    • Characteristics: The log-normal distribution is not characterized by heavy tails but by asymmetry, as it models the distribution of the logarithms of returns. It implies that returns are multiplicative rather than additive.
    • Applicability: The log-normal distribution is often used to model the prices of individual stocks and other financial assets. It accounts for compounding returns over time, making it suitable for asset pricing and portfolio theory.
  5. GARCH Models:
    • Characteristics: GARCH (Generalized Autoregressive Conditional Heteroskedasticity) models do not specify a specific probability distribution. Instead, they model the volatility of stock returns over time, capturing the clustering of volatility and changes in volatility.
    • Applicability: GARCH models are particularly useful for modeling the time-varying volatility in financial markets. They provide a framework to describe the changing risk environment in stock markets.

In practice, stock market returns often exhibit a mixture of these characteristics.

While the normal distribution is commonly used for simplicity, models that incorporate heavier-tailed distributions like the t-distribution or GARCH models are often better at capturing the observed behavior of stock market returns, especially during periods of market turmoil when extreme events become more frequent.

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