Efficient Market Theory from a Trading Perspective
Efficient Market Theory from a Trading Perspective
The Essence of the Theory in Simple Terms
If a trader is fortunate enough to discover a market inefficiency that allows them to exploit the system (from the term abuse) and extract profits with relative ease, they know for certain that the fewer people know about this "holy grail," the longer it will remain effective.
This simple empirical rule is familiar to nearly all traders, even those who are not acquainted with the Efficient Market Hypothesis (EMH).
Inefficiencies come in various forms, most of which lie either in technical factors or market insider information.
Recommended
Read Michael Lewis’s book “Flash Boys: A Wall Street Revolt”, which describes the evolution and development of the technical and software infrastructure of the exchange, generating opportunities for easy money.
The Market Reflects Everything
The Efficient Market Hypothesis (EMH) asserts that the market reflects everything. As soon as specific information—news, force majeure events, technical bugs, etc.—becomes available, it is instantly absorbed by the market and factored into the asset price.
What influences a stock price more—anticipation or the publication of a positive report? The answer is obvious. Every savvy player wants to buy the stock earlier and at a lower price.
Thus, the main takeaway from EMH for traders is that if any informational advantage offers a chance for extraordinary profit, the time before the market reacts and the window of opportunity closes is exceedingly short.
The EMH was formulated by renowned economist Eugene Fama.
Three Main Forms of Efficiency
- Weak Form Efficiency – The price incorporates all historical information, making it impossible to predict future prices based on past trends, challenging the validity of technical analysis.
- Semi-Strong Form Efficiency – The price reflects all historical and current public information, questioning the relevance of fundamental analysis.
- Strong Form Efficiency – The price includes all information, even non-public data.
Numerous studies have been conducted on the Efficient Market Hypothesis, but only the weak form and, to some extent, the semi-strong form have been confirmed. It has been proven that non-public information, available only to select specialists, exists and enables them to earn above-average returns.
Is This Theory True?
The simplicity and persuasiveness of such logic do not guarantee the validity of the Efficient Market Hypothesis. Rational individuals do not have unlimited financial resources, short-selling stocks is often costly and complex, and general price arbitrage can hinder the realization of many strategies. John Maynard Keynes warned that “The market can remain irrational longer than you can remain solvent.”
There are also theories suggesting that rational investors often follow irrational market participants because they cannot always afford to act against them.
Preconditions for Market Efficiency
- The stock market has a large number of rational investors who constantly analyze and trade.
- Investors are provided with truthful, affordable, and up-to-date information.
- Investors react accurately and quickly to new information.
- Transaction costs are low.
- The market is highly liquid.
- No participant has a monopoly or privileged position.
- High-quality market infrastructure and regulation.