The essence of the theory in simple words
If a trader is lucky and finds some inefficiency that allows him to abort the market (from it) and take money out of it with sufficient ease, then he knows for sure that the less people know about this grail, the longer it will work.
This simple rule of thumb is known to almost all traders, even those who are not familiar with the efficient market hypothesis.
Inefficiencies come in many forms, most of them lie in the realm of either technical or market insider.
Read Michael Lewis’s book “Flash Boys. The High Frequency Revolution on Wall Street”, which describes the evolution and development of the technical and programmatic infrastructure of the stock exchange, which gave rise to one possibility or another for easy money.
Michael Lewis, Flash Boys: A Wall Street Revolt
The market takes everything into account
The efficient market hypothesis states that the market takes everything into account. As soon as certain information appears – news, force majeure situations, technical bugs, etc. – it is immediately absorbed by the market and incorporated into the price of an asset.
What affects the share price more – expectation or publication of a positive report? The answer is obvious. Every savvy player wants to buy stock early and cheaply.
Thus, the main conclusion from the TER for traders is that if some information advantage provides an opportunity for super earnings, the time before the market reacts to it and the window of opportunity closes is extremely short.
The famous economist Eugene Fama has justified and deduced the EMH (efficient market hypothesis).
There are three main forms depending on the efficiency
1) Weak form of efficiency – the rate contains all historical information and therefore it is impossible to forecast the rate based on the past rate, which makes technical analysis questionable.
2) Moderately strong form of efficiency – the rate contains all historical and current public information, which makes fundamental analysis questionable.
3) Strong form of effectiveness – the course contains all information, including non-public information.
Much research has been done on the theory of efficient markets, but only the weak and partially moderate form of efficiency has been confirmed. It has been confirmed that there is non-public information, available only to a select few, on the basis of which they earn above average income.
Is this theory correct?
The simplicity and persuasiveness of such logic does not mean that the theory of efficient markets is really true. Rational people do not have unlimited financial resources, short-term stock sales are often costly and complicated, and general price arbitrage interferes with many strategies. John Maynard Keyneson warned that “the market may well remain irrational longer than you can remain solvent.”
There are also theories that rational investors often join those who act irrationally because they cannot always afford to go against them.
Prerequisites for market efficiency
- The stock market has a large number of rational investors who are constantly analyzing and trading.
- Investors are given plenty of truthful, cheap and up-to-date information.
- Investors respond accurately and quickly to new information.
- Transaction costs are low.
- The market is highly liquid.
- No participant has a monopoly or privileged position.
- Quality infrastructure and market regulation.
How to put the theory of efficient markets into practice
Our company provides training on strategies that exploit market inefficiencies. Each strategy has a rationale and definition of how, why, and whose money we are targeting in our strategy.
As you know, the market doesn’t print money, it only redistributes it, so trading is a mutual attempt by buyer and seller to outbid each other.