Friday, May 03, 2019

Are Markets Efficient or Effective? πŸ€” Can Market Profile and AMT help in market analysis? 😎




Are markets efficient or effective? 

This has been the debate that is going on for years. The efficient market hypothesis states that you cannot read the markets or make returns greater than what the index achieves in a year. On the other hand, those who believe that the markets are effective, say that you can beat the markets on a consistent basis and create excess returns. What is true, we are going to find out in today's episode...

Why should you listen to me?

I'm dean from dean market profile and I have been trading markets for the last 14 years. I have been a part of this debate over the years. Now I believe it is time to put it on record what I believe about whether the markets are efficient or effective. We conduct a regular weekly wrap up session for nifty and banknifty using market profile analysis on this channel. But not only we do that, but we also do a bunch of cool stuff related to technical analysis, like today's video where we are going to discuss whether the markets are efficient or effective.

Let's dive in...

Efficient Market Hypothesis

So what does the efficient market hypothesis tells us? I've taken this from Wikipedia, which is the open source of information.

The efficient market hypothesis is a theory of financial economics, which states that all the information is already factored in the price of the stocks. The direct implication according to this theory, is that you cannot beat the markets or create excess returns above an over of what the indices do, or the stocks do.

Types of Efficient Market Hypothesis

Now, there are three forms of efficiencies as described in this efficient market hypothesis. As it is, it is quite complicated and difficult to understand, but now they have also brought in three forms of efficiencies. But they're pretty basic.
  1. Weak Form
  2. Semi-strong Form
  3. Strong Form
Let's go through that one by one...

Weak Form

The weak form efficiency states that future prices cannot be predicted. Looking at the past history of that particular asset or instrument. Now, this is one thing that I agree with. I also believe that you cannot look at the past price data and then predict what the market or the stock or the instrument is going to do in the future and that is just not true because markets are continuously evolving and it's not a mechanical thing or a mathematical thing. Where you know if you control the inputs the outputs will change accordingly. It's a thing where emotions run high and whenever there are human emotions involved, you just cannot predict the outcome of that particular thing. It's no different for the markers.

Semi-strong Form

Then comes the semi-strong form. Now what it tells us is that share prices or asset prices, adjust themselves according to the available information in the markets. So whatever publicly available information is there, the markets or the share prices or the index prices will adjust themselves to that price and markets will move only when some new information comes in.

Now since that the nature of the new information in itself is unpredictable efficient market hypothesis states that you cannot predict the market based on the information that is not yet available. Now I know this is not the case with markets because most of the times that information is available to a group of people or few people sometimes legally, sometimes illegally. And whatever actions they take, reflect in the price and if you can spot that you can spot opportunities. So that is a semi-strong form of efficiency.

Strong Form

And then we come to the strong form efficiency which states that prices reflect all forms of information, whether it is private or public. Well, this makes a little bit more sense because obviously, the information is available to a few people before the general public. And, if those few people decide to act on that information, and that information is legally obtained, and if they are allowed to act on that information, obviously they have an edge over the public right?

Whenever this section of the public who have that advance information act on the markets their buying and selling leave trails in the market. And if you can pick that up, you can trade the markets based on that information and you can make money in excess off what the index average returns are.

The objective of the Markets

Now before we move on to the other part of the equation, that is the effectiveness of the market. We need to first understand why the markets exist or what is the objective of the markers, right? So the primary objective of markets is trade facilitation. And what do I mean by that? I mean by that is the market exists so that buyers and sellers can come in and conduct business. If they want to buy, they should be able to buy and if they want to sell they should be able to sell in the markers, right? And that is exactly why the markets exist.

The secondary objective of the market or more of a byproduct of this buying and selling is the discovery of the fair price, right? Many people think that markets exist to discover the fair price. No. It's a byproduct. Nobody's there to discover the fair price. Everybody's there to maximize their own benefit. Right, so if you go to a grocery store what you're going to do, if you bargain in the market, what you are trying to do is to get the maximum benefit out of the money you are ready to spend.

At the same time, the person who is selling you something is trying to get the maximum for this product so both the parties are trying to maximize their own gains. They're not there to discover the fair price. It is a byproduct because whenever the buyers and the sellers, agree to conduct business, it is a fair price at that particular point in time for both buyers and sellers, they might not be happy about it but it's a fair price.

Auction Framework

This discovery of fair price is done through what we call the auction market framework, but what auction market framework states is that if markets are going higher or up they're basically going up to find sellers and if they are going down, they are basically going down to find buyers. Now, these are the two simplest of statements, you know, very simple statements, just a few words that summarize this auction market theory, but this simplicity, you should not let it fool you into thinking that it's not effective.

This particular theory is very, very strong, it underlies all business transactions, right? The markets are no different. So if you can understand the theory and its principles and its nitty-gritty, your ability to understand the markets is going to skyrocket.

The two statements...
  1. Markets go up to find sellers...
  2. Markets go down to find buyers...

Basic Underlying Principle - Supply and Demand

Are based on the simplest of laws. That is the law of supply and demand, right? So if the market is trading at a certain price and the sellers feel that it's not a fair price for them to sell, so they won't come in and they won't sell. What will then happen is that the auction will have to move higher at a higher price to find sellers who are willing to sell. because the whole purpose of the market is to facilitate trade. So if there is one party is not available to conduct business, the market will move in that direction to find that party.

So we all know that supply increases when the price increases. So if the sellers are not in the market at a particular price, the auction will explore up who find those sellers. And what about the other way round? Let's say markets are trading at a certain price and there are no buyers. Nobody's willing to buy because they feel that the price is very high. It's very steep. What will happen, that particular product share instrument asset whatever it is, it won't find any buyers? There won't be any transactions and to sell that inventory to sell that particular product, stock asset, whatever. It will have to come down to a price where the buyers are again willing to conduct business. Unless and until there is this kind of adjustment of the price, transactions cannot take place.

And this particular adjustment is what we are trying to trade. But before we move on, if you feel that this particular auction market theory framework or AMT helps you improve your market understanding a little bit, a tiny little bit, and believe me guys, once you start using it, when you start analyzing the markets using this auction market theory framework, your understanding of the markets will go up.
  • Why the markets do what they do? 
  • Why the market is going up? 
  • Why the market is going down? 
  • Why it is consolidating? 
  • Why it is not breaking out? 
All these questions will find logical and valid answers which you will be able to use in your trading. So I believe it's a, it's a fair deal. So if you feel that AMT is going to help you improve your market understanding, just go into the comments and type "AMT Rocks" for me. Let's see how many of you feel that auction market theory can indeed help you in your trading.

Why the market is Effective?

All right, let's move on. So why the markets are effective now we talked about information and how you know the information is factored in the share prices and only new information can change the prices, but the new information is not public, it's not available. So it's not predictable and all those things we've talked about. But there are certain characteristics of information that we need to understand before we move on and see the fact that markets are indeed effective in what they do. And that is the whole point of it.

Characteristics Of Information

So how the information gets distributed, there are a few aspects to it. There are three actually...
  1. Time 
  2. Concentration 
  3. Interpretation

Time

How does time affect the distribution of the information? Now by time, I mean the time it takes for the information to reach everyone. I don't watch news channels, I don't read newspapers. I don't read magazines related to markets or financial instruments though I am a full-time trader. I don't do all these things. I also don't browse websites aimlessly to, you know, uncover information, some hidden gem, which can give me some profit just does not work that way.

So if something happens, it usually reaches me very late, you know, as simple as an RBI announcement. Many of the times it does happen on my telegram channel. You guys are there and you know that I'm most of the times not aware of an impending RBI announcement, which is not a good thing.

You should be aware of all those things. But the way I have, uh, you know, developed my understanding of the markets or the way of looking at the markets and just not bothered about what the events are playing out something or other in this auction market theory gives me an advance warning whether there is going to be a chance of heightened volatility or not. And usually, this happens when there are events, right?

So this information reaches different people at different points in time. Some people are privy to this information very early in the game and that can help them a lot. If it's a very powerful piece of information, they can position themselves in the markets and benefit from it. Now, it's not always legal. It's not illegal too, so as long as they're obtaining that information legally it's all good. Alright.

But few people... The general public, they receive that information very late. And by the time they receive that information? And then they interpret it, uh, and then decide to take action. The market has already moved and this happens a lot of times. You know, usually, around results season. You go into a stock, you believe that there is going to be a certain increase in profits, by 50%, then you believe that the stock is going to go up.

The results are announced. The profits are as per the expectation and you buy and you see that the market actually or the stock actually tanks. And the reason is some of the people had that information already. They had already acted and marked the prices or the general public had marked the prices up for that stock in anticipation, right? All these actions can be interpreted before time, you know, notwithstanding what the result was.

But since all these things happened, when the information actually came into the market, all people had already bought, there were no more buyers left to act on that information apart from you or a few others. And all those who had bought they say that the profit is only as expected not greater than that. And then they tend to try to rush out of their positions and that causes that big quick fall in the markers. So that is how when information reaches different people matters a lot.

Concentration of Information

Then we come to the concentration of information. And what do I mean by that is information is concentrated with Some people more than the others by the time the information reaches you through popular media channels like websites or news channels or newspaper or magazines it is diluted. The information has exchanged hands with so many people and most of them have acted on it and that just, you know, reduces the effectiveness of that information. So the information tends to be concentrated with people who have better knowhow.

So if somebody is in a particular business and knows ins and outs of that business, she does not have to know everything to see changes in that business environment. Let's say it's IT or it is banking or whatever and the person is in that industry and he knows that what the key drivers of the prices are. And if she sees changes happening in some of them, she can anticipate changes in others. Right? So the information is concentrated on that person because he has better know how. Now you cannot have a know-how of all industries and all the businesses. So what do you do instead? You look at the markets, you look at the information generated by the markets, which we call market generated information in auction market theory. And you try to use that to your advantage.

All right. So if the information is concentrated, obviously the scales are tipped in the favour of the person who has the information, right?

Interpretation

And then we come to the interpretation. The information is not directly passed on to the end user or people general public. It is often interpreted by the so-called experts and they interpret it for you and then they give it to you. Now that interpretation can be right or wrong, can have different kinds of effects on, on the share prices, on the psyche of the people who are listening to those experts. So the information is not just clean, unbiased information.

It is interpreted and a lot of personal bias of that person who is interpreting the information comes in. And then there's just so many different aspects and drivers which change the effectiveness of that information. Right?

So these three things, the time, concentration and interpretation of information, makes it impossible for the prices to reflect it at all points in time.

Availability of Information Does Not Mean Traders Act on It

Even sometimes when the information is in, you know, just a public domain, the share prices do not reflect that because the traders refused to believe and share prices move because the traders buy and sell. It does not move based on some mathematical equation. So the traders refuse to believe a certain thing, they won't act on it and if they won't act on it or share process won't change even though the information has changed, right. So that is where this efficient market hypothesis, is a bit dicey.

Perception of Information

Then we come to the perception of information. Now just because somebody has that information does not mean that he will act on or he finds it important or he finds it actionable right. As I gave you an example of the banker, or industry experts unless and until you have a sound understanding of that particular business environment, the key drivers of the business, whatever information that comes to you, you won't be able to act on it as good as perhaps some of the experts or some of the people with experience in that sector can.

Even if you do not have to have actual industry experience, I have seen traders who have just tracked a certain sector for years and they have developed a feel for that. So they know what is going to happen. So if the RBI is going to raise it 50 basis points, the rates by 50 basis points, they know what effect it is going to have. And it's not always bad, it's not always bearish because they know the pulse of the industry. And that is why they can be so good.
You don't trade the markets, you are trading other traders who are competing for the same opportunity. - Dean Market Profile
So if you have that experience, if you have applied yourself, if you have the right tools and right way of looking at the markets and information, you can beat the market. And you are not actually beating the market, you are actually trading against the other fellow trader. So if the other traders are not well prepared and well informed and they don't have the tools of the trade, then obviously you have a bigger advantage of them and you can consistently make money in the markets.

Biases

Then we come to biases. Just because you have information does not mean that it is going to help you. Because what you do is based on different biases. We are just going to discuss three of them...

  1. Confirmation bias...
  2. Recency bias...
  3. Survivorship bias...

Confirmation Bias

What is confirmation bias? Whenever a person discovers something that person gives additional weight to that information. So if I go into the markets, I have just learned about let's say triangle pattern, pennant. I go into the stock charts, I sift through hundreds of charts and then I discover one particular share which is actually forming a pennant pattern. And since I have discovered that particular pennant pattern, what I believe is that that pennant or triangle is going to resolve in a certain way and I'm going to make a lot of money now just because the prices are converging does not mean that they're going to explode.

They can just keep on converging. They can just move sideways. And if you believe it is going to go up, it can go down. Funny things can happen in the market. Nothing is guaranteed, right? The real thing is that you should know why it is doing what it is doing.

The confirmation bias completely beats the purpose because you tend to put in additional weight on the information that you have discovered. That is very dangerous situation.

Recency Bias

The second is recency bias. Whatever has happened recently controls more of your mind space, than whatever has happened in, say, distant past. And that is why the traders don't improve. They do make mistakes. They do learn from their mistakes, but they just don't keep it in their mind.

And then there is this saying in the markets that...

"You are as good as your last trade."

Its bullshit. It's not like that.

You are as good as the lessons you have learned and remembered and applied to the markets. It's not about your last trade. My last trade is a loser. What does it mean? Does it mean that I'm a bad trader? Its not like that you're always going to have losses and you are always going to have profits. So what you do with those learnings is what matters.

So you just cannot rely on the recent information. That is why, you know, the media works. Day in day out they are just pushing a lot of information. But just because it is recent information, people get hooked on to it and they cannot let go of it. That is why I've stopped watching those news channels.

Survivorship Bias

And then we come to the last of the bias and that is a survivorship bias. And what it means is that people tend to look at the survivors. Let's look at our favorite movie stars. We have Amitabh Bachhan Shahrukh Khan Salman Khan and all these guys out there. They are very popular but when they were starting out in the industry there were hundreds of other aspirants who wanted to become heroes in bollywood. But did they succeed?

No, only a few people succeed. There are great stories of struggle, of passion, of hard work. Everybody did that. But then why only a few succeeded? That is because we tend to focus on those few only and we tend to ignore all of those who did not succeed despite putting in the hard work despite putting in the passion, despite having, you know all the love for the craft.

That is what survivorship bias is. If you go on to twitter and you see that people posting the screenshots of the profits, but that's just one profitable trade. And whenever they have a profitable trade, they tend to share it. So what do we believe is that they are making profits consistently. But that is not the case. They won't come in and post that they have lost of 50% of their capital on one trade. They won't do that. You always tend to look at the successes and we tend to believe it blindly.

Human Behaviour Hinges On Hope

That is how the human, behaviour, behavior works it, it's driven by hope. We hope that it is true and then we try to follow these guys and then we get disappointed later on when we discover that it was all hogwash. So you have to be aware of their survivorship so it's not just about information, all right?

Its all of these things and all these things are human things. As long as human beings are trading the markets, I don't believe efficient Market hypothesis will hold the markets. However, are very effective in distributing the prices in such a way that most of the people in the markets get to business.

If they cannot either they will have to lower their prices if they are sellers or they will have to increase their prices if they are buyers to reach a particular level and conduct business. All these things can be understood by the auction market theory. It might seem a bit confusing but it can be understood by auction market theory. There is a brilliant tool which can be used to apply all these principles in real time markets to pick profitable trades and that is Market Profile.

Risk Is Supreme Consideration - Period!

Okay, so last is you have information, you have perceived it and then act on it. Now every person is going to act in a different way.

No trader has the same amount of capital as the other, I have X amount of capital. Somebody may have 10X, somebody may have half my capital. All right. People don't understand leverage.

Now what happens is that if you over leverage, it works both ways, guys. It can give you great profits but can wipe your capital out equally quickly. When that happens, the person won't blame the over-leveraging what that person ends up doing is blaming the tools that he's using.

Be it Market profile, Elliott Wave Analysis, technical analysis, whatever person ends up blaming the tools and then he moves on to the next. The real problem was actually leverage. All right, so even though a certain person has a piece of information that is good information that is actionable information, but if he is not following the simple rules of risk management and trade management, whatever information he has, it's very difficult for him to make profits consistently in the market.

So it's not just about information, it's about how you act on that information. It's about how you perceive that information. Makes Sense. Let's move on.

To Err is Human

We are all human beings and we do screw up repeatedly. It does not matter how much you know, efforts you put, whatever you do, maintain a trade journal make flashcards placards whatever you do you are going to screw up one time or another?

The only thing that you can actually control is your risk. If you can manage your risk, you can stay in the game longer, make all the mistakes, learn from them, make it again, make it so many times that you start recognizing it before you start making it. But to do that you need to stay in the game and to stay in the game. You have to keep your risks very, very small.

So what I would say, at the end of this is that markets are definitely not completely efficient, but they're really, really effective in letting buyers and sellers do their business. I am of the belief that markets are effective and that is what makes me come to the market in anticipation of making profits. And if you have the right tools, the right mindset, the right way of looking at the markets, you can actually make consistent profits in the markets.

Question Of The Day

So before we leave, let me ask you a question.

Do you believe markets are efficient or effective?  

If you believe the market side effective just write effective in the comments and perhaps give me a reason why it is effective.

If you still believe the markets are efficient, then write efficient in the comments and tell me why you believe that they're efficient and we can have a good conversation in the comments.

So if you liked this post, I would suggest you give me a thumbs up. Because I have put in a lot of efforts into that. And if you can share it with one person, just one person who may find this particular information useful I would be really grateful. You can use the share button below the post and you can share it with just one person who may find this video useful. Because...

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