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What is an Order Parameter?

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  • Written By: Toni Henthorn
  • Edited By: W. Everett
  • Last Modified Date: 15 September 2016
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In finance, an order parameter refers to a critical value of a variable in the complex interplay between investors and the financial markets at which a fundamental change in the phase of the stock market occurs. Order parameters form part of financial equations that are used in econophysics, a discipline that applies formulas and methods traditionally used in the field of physics to the study of financial markets. Econophysicists have postulated that the stock market has two phases, one in which the buying and selling of stocks is roughly at equilibrium and one in which either buying or selling predominates. The order parameter indicating the shift from one phase to another is volume imbalance. Investors can predict phase transitions within the market by tracking transactional data, calculating the volume imbalance, and plugging that value into an equation.

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Scientists have long sought to classify how items of interest change over time. They have discovered that seemingly chaotic systems, while appearing to be haphazard, behave in predictable, albeit irregular, ways, given the stimuli or conditions present. This field of study, called nonlinear dynamics, analyzes the interaction among diverse miscellaneous factors in a system in an attempt to discern an underlying hidden order. The financial market, which involves a substantial number of humans interacting under a variety of circumstances, fits a nonlinear dynamics model. In econophysics, mathematical equations can predict a variety of variables, such as momentum, volume changes, acceleration, and investor psyche, utilizing order parameters, in order ultimately to forecast price changes.

In physics, an order parameter indicates the level of order in a system. The more a variable deviates from the order parameter, the greater the likelihood of a phase transition. For example, when buyer-initiated transactions exceed seller-initiated transactions by a critical threshold amount, the market transitions from equilibrium to a high-demand scenario, which will drive prices upward. Conversely, when seller-initiated transactions predominate over buyer-initiated sales, deviating from the order parameter, the shift from equilibrium to a low demand status drives prices downward. The volume changes occur prior to the price changes, theoretically allowing investors to make wise decisions regarding entry and exit market strategies.

Order parameters may reflect independent variables or a combination of variables. For example, in weather forecasting equations, an order parameter consisting of changes in temperature may represent the combined effects of changing air currents, sun exposure, and cloud cover. Likewise, when a substance transitions from one phase to another, the order parameter of the system is the density of the particles. Although temperature, wind and movement affect whether ice melts or water vaporizes, particle density determines the phase. Similarly, investor sentiment or demand when used as an order parameter encapsulates all of the fears, beliefs, motives, consumer perceptions, and general psychology of the trading population.

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