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Why it helps to think in terms of Market Efficiency

What is lurking in the minds of many traders is the notion of whether markets are efficient or not. Now to be a trader as opposed to a gambler, a central premise resting in your philosophy is the principle that an edge can only be found in a market with inefficiencies. If the distribution of returns made available to a trader falls within the description of a normal (Gaussian) distribution, then the game is over in the long term. Lady luck may allow you to survive for an extended period, but the Law of Large Numbers will get you in the end.

So as a speculative trader we hold onto the notion that while the market may be very efficient at times, there may also be times when the markets are inefficient. The degree of inefficiency leads to opportunities for the trader which account for their edge.

What many long term traders have suspected over time is that markets are actually quite efficient and becoming ever more so. That is the whole point to a market. To create an efficient marketplace where buyers and sellers can transact at ‘fair value’. Inefficient markets are like barter economies or new market opportunities such as crypto-currencies, new issues, new indices etc. where initial inefficiencies are slowly whittled away by more and more participants interacting.

What this means particularly for well established liquid currency markets are that non-efficient moments when ‘real’ opportunities can be taken by traders as opposed to random luck or ability to exploit a single market condition are fleeting in nature and seldom long lasting.

You find that this ultimately impacts the length of time that you can survive in this market as the element of effective randomness of outcomes takes a long time to play out when non-leveraged….but a quick time to play out when leveraged.

Unless you can find an enduring edge in this market with a particular technique that can survive over an extended array of different market conditions (or data set), this therefore forces you to continuously adapt to altering market conditions and to find new ways to harvest the occasional non-efficient anomaly that comes your way. This puts severe pressure on the trader to not only be prepared to adapt to new techniques….but also to find new techniques with an actual edge.

As markets become more efficient, your ability to find an actual edge in the game decreases. You may be fooled into thinking that you have an edge in a particular ‘fairly stable’ market condition, but as soon as a disruption occurs in those conditions and a new market condition is generated…you realise quickly that your solution no longer works. You therefore did not have an actual edge in the first place.

Accepting that the market is efficient most of the time does two things to your trading psychology. It forces you away from even caring about a single trade to one of simply caring about the next few thousand trades and ensures for your long term survival that you must seriously reduce your return expectations, leverage appetite and focus on risk management.

These fleeting inefficient times means that you need to be in the game to participate in them….but to be in this position you must be a survivor. The only real way to achieve this is to protect your capital base at all times the market is efficient so that you are available when the unpredictable non-efficient anomaly comes your way.

Trade well and prosper

 

Rich B

 

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