Essentially, Efficient Market Hypothesis (EMH) says that all the news relating to the stock market has already been disseminated and priced into the market. Some examples of the wide range of items that already priced into the market include earnings (or other binary events) as well as if the market takes a downturn.
Any information that exists that could affect a stock’s price has already been priced into the market.
Our resident smart guy, Jacob, does a fantastic job explaining the different forms of EMH in his Skinny On Options Math segment. I’ve pulled text from his slides below:
“The EMH states that current market prices reflect all current information. To be more precise, it comes in 3 forms:
1. The weak form: says that current prices in the market take into account all information contained in the past prices in the market. This form is incompatible with systematic success of technical analysis. Future prices cannot be predicted from the past.
2. The semi-strong form: further says that current prices reflect (at least very rapidly) all publicly available information. This form would rule out the effectiveness of fundamental analysis. Prices adjust to all available information almost instantly, meaning that nobody can profit from new information consistently.
3. The strong form: says that even private information is nearly instantly reflected in market prices. If there is any compliance with insider trading laws, this should be impossible.”
At tastytrade, we don’t operate under the assumption that we can make money because we know something someone else doesn’t. Instead, we believe that all of that information is already priced into the market. We use domain expertise and effective strategies to maintain profitability, including:
- Number of occurrences - A Market Measures segment on the ‘Law of Large Numbers’ explains how increasing your number of occurrences can bring your average probability of profit up to expected values, thus increasing your success rate. That basically means that we look to trade many iterations around high probabilities, and over time, our probabilities will be accurate.
- Managing winners - A Market Measures segment on ‘A Reason To Manage’ explains how managing your trades earlier in the cycle ensures that we do not run into decreased theta decay and increased gamma risk as expiration approaches. Through this study, we realized that the average time to hold a trade is 27 days (holding the trade for an extra 19 days doesn’t make any sense as the majority of the money was made early on).
- Selling premium - A Market Measures segment on ‘Premium - Why Selling It Works’ explains how historically buying premium (through strangles) results in wins 17% of the time, whereas selling premium results in wins 84% of the time.
- Reducing our cost basis - A Market Measures segment on ‘Cost Basis Reduction and Probabilities’ shows us how selling options (rather than just buying stock) increases our Probability of Profit by 20%.
One of the main reasons an average investor underperforms the benchmark (S&P index) is because of lack of domain expertise. Large prop firms and market makers consistently make money because they approach trading with strategies in mind. If EMH holds true, then technical or fundamental analysis give you no particular edge as the market already reflects any information that you might have.
EMH is especially true for markets that are highly liquid and tight. Markets that are penny-wide have to be efficient, because you are able to buy and sell with a penny between the bid and the ask price. You get tighter markets because there is less risk for the market maker (for the other side).
Understanding EMH and being able to deploy sound strategies when trading is what makes the retail trading market so exciting. The more you listen to tastytrade, the more you learn, and therefore the more you will be able to increase your domain expertise. This will lead you to use strategies that professional (institutional) investors use, and also allow you to develop the mechanics necessary to be profitable.
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