# Why do we make the Markov assumption on financial markets? [closed]

Why are Hidden Markov Models (HMM) a good fit to describe the behaviour of the prices of financial assets, when these models require that the underlying stochastic process satisfies the first-order Markov property?

According to such property, the probability of future events it's only determined by the current state of things. However it's commonly known among technical traders that trend lines, support/resistance levels, previous candels formations, etc. play a big role in determining prices. What am I missing? Are these factors implicitly taken into account when the HMM is trained through the Baum-Welch algorithm?

• However it's commonly known among technical traders that trend lines, support/resistance levels, candle formations, etc. play a big role in determining prices.'' I think it's commonly accepted that under (informationally) efficient markets such technical trading systems do not work. The idea that historical information is incorporated in today's prices and you cannot generate an alpha based on that information is standard in finance (EMH) and in financial modelling (almost all stock price models are Markovian). – Kevin May 10 at 12:08
• It is not clear what your intended modelling purpose is: pricing or investment? The Markov property boils down to the EMH hypothesis in financial theory. Academics define 3 types of EMH: weak, semi-strong and strong. There is ample evidence that weak EMH holds, whereas there is some evidence that strong EMH does not hold (evidence for semi-strong is mixed). Thus, for the purpose of pricing derivatives, assuming Markovianity is equivalent to assuming EMH which, given the empirical evidence supporting the weak form, is a reasonable hypothesis which eases the theory of derivative pricing. – Daneel Olivaw May 10 at 12:50
• For the purpose of investing, models which leverage past information, such as past stock prices or public accounting data, it is of course inconsistent to assume Markovianity, as it would imply your model does not leverage any past information to try to predict future prices. – Daneel Olivaw May 10 at 12:52
• quant.stackexchange.com/questions/35335/… – Daneel Olivaw May 10 at 19:09
• Finance research has dealt with that question for decades. The overwhelming evidence points towards efficient markets and unskilled fund managers. Warren Buffett's example is on the same level as pointing to your 90 year-old smoking granddad. Nice for him but it does not quite disprove medicine... and "often looking at charting systems" is nice, but if you code such a system and run a proper backtest, there remains no statistically significant alpha. People from behavioural finance (e.g. Shiller & Thaler) don't think money lies on the street either. Buffett himself recommends buying an ETF... – Kevin May 10 at 19:16