Saturday, July 22, 2006

Efficient Market Theory

Recently I read's Stock Analysis Overview, which is part of their free Chart School Educational Information. I've been reflecting on the concepts presented therein and it's helped me understand the principles behind much of what EduTrades, Inc. (Teach Me To Trade) teaches. As noted, I'm new to stock & option trading and I'm doing all I can to soak up more information and opinions. Although it's not the only thing TMTT teaches, technical analysis is certainly paramount to TMTT's system of trading. Technical Analysis should be incorporated into any investment strategy for trade entry and management, but it's absolutely essential to being a Professional Trader.

The overview is a presentation of theories that are the basis of a trading or investment system designed to "beat the market." There are scores of people on wall street and around the world that are attempting to do just that. It seems logical that the way to beat the market is to exploit anomalies that exist at any given point in time. So how do you know what's anomalous? This is one area where technical analysis excels. If your technical analysis leads you to believe that a particular security is overbought or oversold, you can enter a position to prosper from the anomaly. Now that sounds all well and good, but it does require accepting Strong-Form "Efficient" Market Theory as a foundation.

Simplistic as it may seem, strong-form theory states that everything you need to know about the company is reflected in its current price because that's the value the market has dictated. Technicians look to trends and patterns in the chart & volume to make money on overbought or oversold stocks. For an efficient market to work, investors need to know all relevant information, including news and fundamentals about the company; investors must also have the ability to act (or react) to such news as quickly as possible. Essentially the price will continually correct itself as news and company information is made available to the public.

The other theories for and exploiting anomalies include the semi-strong form and the weak form. The weak form of the market dictates that the fundamental information behind a stock determines its actual value. The discrepancy between the current price and the expect value based on your fundamental analysis is the anomaly that we can exploit. For example, if your fundamental analysis leads you to believe the stock is underpriced relative to it's value, you'd be bullish on the stock and seek to profit as the trading price approaches the value that you've determined from your fundamental analysis.

Although I don't think this approach is worthless, there are many times the price of the stock does not react the way you might expect. When good news comes out about a stock, this system dictates the price should increase, but there are numerous examples of the exact opposite happening if not nothing (no increase) at all. Even if you were a fundamentalist who whole-heartedly subscribes to the weak-form market theory, knowing a good technical setup can certainly benefit your bottom line.

The most interesting theory (yet the most worthless for the basis of a trading or investment system) is the semi-strong form of the market, aka the "random walkers." This theory basis itself on price corrections happening (much like the strong-form theory), but that the only way to profit from such price corrections is to know the news ahead of the public at large. The idea behind this is that, although all known information available is reflected in the current price, there is inevitably information that is not public (think insider trading). Without such insider information, the markets behave in a rather chaotic, unpredictable way. Thus making the ability to "beat the market," a near impossibility without insider information. I don't believe this is the only way to beat the market, however I do believe a certain level of insider trading does exist. I say this only based purely on human nature; I'm not so much an idealist, nor so naive that I believe everyone is honest and forthcoming all the time, especially when they stand to profit from withholding such information.

Granted, I'm new to all this, but it seems the market has become more efficient as the delivery of news and the ability to act on that news has become more immediate (and cheaper). Therefore, in today's world of up-to-date news available at the click of a mouse, and the ability to act on that information with similar speed and ease, we have a more efficient market than we've had in the past. It also seems realistic to expect that the markets will become more effecient and possibly more predictable. Consider if everyone is using the strong-form (effecient) theory to determine their trade entry & exit; in such a situation, the stock should exhibit a normalized, semi-predictable behavior. Of course this could all just be in my imagination as I conceptualize how trading & the markets work.

1 comment:

T said...

Dear friend,

I stumbled up on your website, because I just signed up to an IB account myself & read your post(nice!).I am a passive investor for a couple of years.

Efficent market theory is dead and buried. Day trading is very dangerous, you have to get 3 winning trades for every losing trade to make small margins. I understand your enthusiasm, but heed this advice, please. You'll lose your shirt. Only way to make money is hold stocks for long periods of time & do say 5-10 trades a year (max).Else, you'll just be paying commissions.

I am programmer too. Read the book, intelligent investor by Benjamin Graham and you'll thank me for it :)

Best wishes,