Independent event is an important part of mathematics, econometrics and also finance. The events that do not affect each others’ outcomes are the independent events. Particularly speaking about the financial markets’ trading domain, independent events play a significant role.
When trading in one of the tradeable items (say, stocks, commodities etc.) of financial markets does not affect the simultaneous trade in other item, it is an independent event.
Let us find out more about independent events with this article that covers:
- What is an independent event?
- Examples of independent events?
- Difference between dependent and independent events
- Real-life example of independent events in trading
- How can a trader utilise independent events?
- Difference between independent events and conditional probability
What is an independent event?
Independent events are the events that occur without being dependent on any event. For instance, flipping two coins can get any outcome, either Head or Tail. Both the flips’ outcomes will be independent of each other.
Hence, if the probability of occurrence of event A is not affected by the occurrence of another event B, then A and B are said to be independent events.
Consider an example of rolling a die. If A is the event ‘the number appearing is odd’ and B be the event ‘the number appearing is a multiple of 3’, then
P(A)= 3/6 = 1/2 and P(B) = 2/6 = 1/3
Examples of independent events
There are several independent events in the day to day life that all of us come across.
General example of independent events
One of the examples can be rolling two dice rolls simultaneously. The result of both dice rolls will be independent of each other. Since both events do not affect the occurrence of each other, they are considered independent events.
Example of independent events in trading domain
For another example, let us consider the trading domain. In the financial markets’ trading, a trader can trade in a portfolio of stocks, commodities and cash. In such a case, the trades are independent of each other since trading in one market is independent of trading in another.
Also, an important point to note is that a trader could trade in both a stock, say, Microsoft and in a commodity, say oil for the purpose of diversification.
Difference between dependent events and independent events
The outcome of one event doesnot affect the outcome of the other.
The outcome of one event affects the outcome of the other.
If two events, say A & B are independent events then the probability of both occurring is P (A and B) = P(A)xP(B)
If two events are dependent events then the probability of both occurring is P (A and B) = P(A)xP(B|A)
Real-life example of independent events in trading
When the COVID-19 outbreak happened, most of the industries suffered losses but there were a few others that did well. The industries such as e-commerce, health and hygiene industries performed nicely during the outbreak. Speaking about the e-commerce industry, the COVID-19 outbreak increased the demand for online shopping.
On the contrary, some other industries such as Hospitality, Aviation etc. suffered losses due to a lesser movement/travelling of people across the globe.
Let us see how the two stocks i.e., PK or Park Hotels & Resorts (hospitality industry) and EBAY (e-commerce industry) performed during the Covid-19 peak.
Here, I have shown the data visually to make the analysis clear.
In the above graph PK (hospitality industry) is shown in green and EBAY (e-commerce industry) is shown in red.
In the above visualization, you can see that the close prices of the e-commerce industry were more than the close prices of the hospitality industry during the covid-19 outbreak.
The graph indicates that the close price of the stock belonging to the e-commerce industry went up significantly whereas the one belonging to the hospitality industry did not rise as much. The hospitality industry more or less remained the same with short spikes in between.
Also, you can visualise the same with a scatter plot in the following manner:
How can a trader utilise independent events?
There are several ways a trader can utilise independent events. Let us see how.
Hedging and Mixed portfolio
Independent events can be utilised by the trader very well if the trader considers hedging and maintaining a mixed portfolio consisting of stocks, commodities etc. Offsetting the losses is one of the main goals of a trader and hedging, as well as mixed portfolios, help with exactly the same.
In order to maximise the returns while trading in the financial markets, maintaining a portfolio is extremely important. When the portfolio consists of different tradeable items such as stocks, commodities etc. they are usually independent of each other with regard to affecting the other’s outcome.
Trading in one market with two tradeable items independent of each other
Also, as we discussed, in the stock market, a particular scenario can make trading in two stocks independent of each other. For instance, the covid-19 outbreak was the scenario in our discussion.
The two stocks, one from the health industry and another from the hospitality industry performed independently of each other in the same period. If the trader hedges and also maintains a mixed portfolio, the volatile market will be less risky.
Also, analysing the volatility period is a huge plus for the financial markets’ traders. For doing so, the VIX index which is a ticker symbol helps. VIX is the well-known name for the Chicago Board Options Exchange (CBOE Volatility Index).
It is a measure of the market’s speculated volatility on S&P 500 Index Options. Also known as the “fear index or fear gauge”, VIX is calculated on a real-time basis by CBOE Volatility Index.
The resulting VIX calculation provides the investors with a measure of expected volatility in the market in future. Based on this calculation, further stock market volatility can be predicted.
A trader can perform historical data analysis for some stocks in volatile scenarios in the past. With this analysis, the trader can be more decisive about what to include in the portfolio for the particular volatile period.
In such a case, trading in multiple industries’ stocks, commodities etc. will be independent events.
Difference between independent events and conditional probability
Two events, say A and B are known to be independent events if one event does not affect the outcome of another event.
If event B is dependent on event A, then it is the case of conditional probability.
Both the events can take place simultaneously or one after another.
One event has to take place prior to another for it to be called conditional probability.
Example of conditional probability
For instance, there is a dependence of the automobile industry on the plastics industry. So, when the plastics industry increases the prices of the plastic, the price of the automobile industry’s one of the raw materials’ increases.
Hence, the price of the vehicles of automobiles industry also rise. This is known as the conditional probability.
Trading in two different markets, in two different tradeable items etc. are independent events since the outcome of each does not depend on any other event.
Although there can be some dependent events such as trading in two stocks from the same industry, say auto industry. Then the performance of two stocks from the auto industry can be dependent on each other with regard to the market scenario.
We discussed the examples of independent events and how you can utilise independent events in the trading domain.
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Disclaimer: All investments and trading in the stock market involve risk. Any decision to place trades in the financial markets, including trading in stock or options or other financial instruments is a personal decision that should only be made after thorough research, including a personal risk and financial assessment and the engagement of professional assistance to the extent you believe necessary. The trading strategies or related information mentioned in this article is for informational purposes only.