Evaluating Major Financial Market Theories

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Many aspiring traders and investors seek to learn as much as they can about the different types of market theories and strategies that they can use to gain a practical edge in their trading. In this lesson, we will focus on comparing and contrasting seven major market theories and the philosophies behind them.

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Efficient Market Theory

The efficient market theory, also known as EMH, assumes that all available and known information about a specific financial instrument is already factored within the price of that asset. As a result, there is no discernible edge in trying to predict the future price of that asset, and those who do so will find it to be a futile attempt to beat the market in the vast majority of cases. EMH suggests that those that do beat the average market returns have most likely done so due to the benefit of luck, and thus are to be considered tail events or outliers.

There are three forms within the efficient market theory. This includes weak form EMH, semi strong form EMH, and strong form EMH. Weak form EMH states that economic or fundamental analysis may provide a short-term trader or investor some advantage that can exceed the average market return. However, that this minor advantage cannot be translated into a longer term edge.

Semi strong form EMH suggest that neither fundamental nor technical analysis can provide an investor with a market beating edge because all publicly available information is immediately absorbed within the price of the financial instrument. The strong form EMH states that regardless of whether the information is of a private or public nature, that information will not provide an advantage to the trader investor over a longer term basis.

Those that espouse the efficient capital market philosophy believe that the best way to invest in the markets is not through market timing theory or models, but rather through a mechanism by which you can be invested in the market as a whole. As such, the recommended vehicle for market investing would include index funds or ETFs.

Both of which are a passive form of investing and allows the investor to track a specific asset class such as equities, bonds, or commodities. The efficient market theory is closely tied to the random walk market theory which also states that price movements within financial assets have a random and unpredictable characteristic.

Chaos Market Theory

Chaos theory was developed by Edward Lorenz, a meteorologist who studied complex weather systems. His theory was later used to explain price movements within the financial markets. Essentially, chaos theory introduced the idea that even the most minor of changes within a complex system can contribute to a large change in system over a period of time.

Chaos theory offers a happy medium between proponents of the efficient market theory and those that believe that price movements within the markets can be predicted. Chaos theory suggests that the markets are both simultaneously random and unpredictable, and have inherent patterns that are complex and can have forecasting value.

This may seem like a contradictory stance, however, chaos theory explains that there are a number of different variables that determine the complexity and predictability of complex systems such as the financial markets.

Chaos market theory can also help explain why manias and bubbles form in the market, and similarly how crashes and panics are fueled. It explains that in the case of market manias, a certain level of optimism which can be seen as a positive feedback can build to a point wherein its momentum can far outpace the point of equilibrium. And conversely, a certain level of pessimism in the market which can be seen as a negative feedback can build to a point wherein its momentum can far outpace the point of equilibrium.

In other words, price movements in the market can persist for long periods of time in either direction due to the underlying feedback loop generated from positive or negative sentiment of traders and investors.

The chaos theory is also closely related to the fractal market theory, which states that the markets, like certain forms in nature, have a fractal or self-similar characteristic that repeat at varying degrees. In other words, price movements in the market have a certain pattern or footprint that can be seen at the largest timescale to the smallest timescale.

Prospect Theory

The prospect theory was introduced by Daniel Kahneman and Amos Tversky. They set out to study the reactions and behaviors of investors in varying situations. Though market participants like to believe that they act in accordance with their best interest as it relates to their financial investing and speculation activities, we know from prospect theory that this is not always the case.

Prospect theory tells us that investors will react very differently when they are put in a situation of realizing a potential loss versus a potential gain. More specifically, investors tend to take on a higher level of risk when there is a chance of a loss thus they have a tendency for loss aversion in these types of instances. On the other hand investors tend to be more reactive to risk when there is a potential for further profit or gain.

Let’s illustrate a scenario based on the assumptions within prospect theory using Apple stock as an example. Let’s assume the stock price of Apple is currently trading at $300 and you buy 100 shares of that stock today for a total investment of $30,000. Fast-forward two months and now the price of Apple is trading at $275.

Based on this you are down $25 a share on the Apple stock position which is equivalent to a $2500 loss on the trade. Prospect theory explains that you are more likely to hold on to that position, thus taking on additional risk, in an attempt to avert that potential loss in your trading account. The possibility of realizing a loss has caused you to invite additional risk into this scenario.

Let’s look now at the flip side of this example. Using the same assumptions, Apple is currently trading at $300 and you buy hundred shares of the stock for a total investment of 30,000. Fast-forward two months and now the price of Apple is trading at $325. In this scenario you are up $25 a share on Apple stock which translates to a profit in your account of $2500.

Prospect theory tells us that now you are more likely to sell your position and lock-in your $2500 profit, rather than take the risk of losing that gain in exchange for realizing a larger profit potential on the trade.

If you’ve followed these examples closely it should dawn on you that the prospect theory reveals the true nature of investor tendencies in real world market situations. And more importantly, that it is in direct contradiction to what most successful traders reveal is critical to making consistent profits in the market.

That is to say that prospect theory explains that traders and investors tend to cut their profit short, and ride their losers, rather than what is considered the more beneficial course of action, which is to cut your losses short, and ride your winners.

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Auction Market Theory

Auction market theory helps explain the price movements of a freely traded financial instrument. The auction market theory is based on the premise that all markets move up, down or sideways seeking fair value or price equilibrium.

The forces behind price movements are based on the underlying supply and demand dynamics which is ever-changing. The introduction of any new information that affects the security will result in the rebalancing of supply and demand to compensate for the newly introduced information or variable.

Auction market theory assumes that markets are moving towards fair value, but that there remain inefficiencies that can be seen and acted upon by informed traders. Auction market traders typically utilize the market profile study to help them find supply and demand inefficiencies and patterns. These traders rely heavily on specific volume footprints as a means to identifying trading opportunities.

Under the auction market theory, a market is said to be balanced when the supply from selling activity is balanced with the demand from buying activity. Traditional technical analysts will view this activity in the market as a period of consolidation or range bound activity.

A market is said to be unbalanced when there is a sudden or significant price move in either direction. Typically markets rotate from periods of balance to periods of imbalance. Technical analysts will recognize this phenomenon as breakouts from consolidation leading to a trend leg.

During an uptrend, the prices are moving higher in an attempt to find more sellers to balance out the high demand of the buyers. Conversely during a downtrend, the prices are moving lower in an attempt to find more buyers to balance out the high supply of the sellers. As such, the markets are continually seeking fair value and equilibrium.

Dow Theory

The Dow theory is one of the oldest financial market theories around. It was developed by Charles H Dow, for whom the Dow Jones industrial average is named. There are a few key tenants within the Dow theory.

Dow theory, which was originally a stock market theory, holds that the markets discount all available information and that everything that is publicly known is already priced into the market. In that sense it is in alignment with the efficient market hypothesis. However, the Dow theory does make room for the possibility that market participants can benefit from market analysis by studying price action trends.

Dow theory holds that there are three types of market trends based on duration. The largest is called the primary trend which can be a yearly or multi-yearly price trend. Primary trends are said to progress within three major phases, with three legs upward and two countertrend reactions within the context of an uptrend, and three legs downward with two countertrend reactions within the context of a downtrend.

Within the larger primary trend, there exists secondary trends which last for several months and will often move counter to the larger primary trend. Finally there is the minor trend which is the smallest scale of trend recognized within the Dow theory, and this trend progresses for several weeks and is less predictable than its larger secondary and primary counterparts.

Volume is an important component within the Dow theory. Dow theory states that a healthy trend is one wherein the volume increases as prices move in the direction of the trend, and volume contracts during countertrend reactions. Additionally, investors are cautioned against acting prematurely against a primary trend which has been in progress for some time.

Elliott Wave Theory

The Elliott wave theory was introduced by RN Elliott in the 1930s. Elliott studied historical price charts within the stock market to derive his wave theory. Under this theory, price movements are considered to move in waves that form very specific patterns that can be seen from the largest degree of trend to the smallest degree of trend.

Additionally the Elliott wave principle tells us that the markets are driven by mass human emotions. And this leaves a footprint within the price action that repeats over and over again.

The primary market structure based on Elliott wave is a five wave impulse structure followed by a three wave corrective structure. The impulse structure moves in the direction of the larger trend, while the corrective structure retraces a portion of the impulse structure.

Within the context of an uptrend, a bullish impulse will form five waves wherein waves 1, 3 and 5 move in the direction of the uptrend, while waves 2 and 4 move counter to the trend. In the context of a downtrend, a bearish impulse will form five waves wherein waves 1, 3 and 5 move in the direction of the downtrend, while waves 2 and 4 move counter to the trend.

And this basic market form is fractal, meaning that it can be seen at the largest timescales such as the monthly or yearly charts down to the smallest timescales such as the one minute or five minute charts.

This 5 up and 3 down structure is believed to be the essential growth pattern within many complex systems, and represents the most efficient path of progress in the natural world. The decisions that traders and investors make in the stock market and other financial markets represents this growth pattern.

The mathematical fabric of the Elliott wave theory is based on the Fibonacci sequence. The Fibonacci sequence is considered to have powerful qualities that can be seen throughout the universe. Within the Elliott wave theory price movements can be projected based on specific Fibonacci relationships among the different wave structures.

Of all the different market theories, the Elliott wave theory provides the most robust and in-depth framework for trading the markets. Not only does it explain the phenomena of price movements in the market, it goes into great detail regarding each type of pattern that can be seen in the markets. There are a total of 13 different Elliott wave patterns which help traders and investors analyze and forecast future price direction of any liquid trading instrument.

Adaptive Market Hypothesis

Adaptive market hypothesis is a relatively new financial market theory that is the brainchild of Andrew Lo, a professor affiliated with the Massachusetts Institute of Technology, MIT.

Under the adaptive market theory, Lo explains that market participants are rational for the most part in their investment decision processes, as the rational market theory suggests, however during times of market euphoria, panic, or other conditions that lead to increased volatility, market participants will tend to become overly influenced by such events in a way that will lead them to make counterproductive decisions.

So in a sense traders and investors will act rationally and in accordance with their self-interest during normal market conditions, but they will be driven by a certain irrationality when market conditions appear to become irregular.

On the bright side, the adaptive market hypothesis also puts forth the idea that investors can and do often adapt to miscalculations and errors that they have previously made, often preventing them from similar mistakes moving forward.

An important component of the adaptive market hypothesis is the emerging field of behavioral finance. Although there has been much progress made in the area of behavioral finance, it is still in its very early stages. Given more time and empirical evidence backing the adaptive market hypothesis, it may gain more widespread acceptance among economists and other market professionals.

Download the short printable PDF version summarizing the key points of this lesson….Click Here to Download

Summary

Before getting involved in any type of endeavor, you should take time to educate yourself on the basics and foundations. This is certainly true when it comes to your investing and trading business. As such, it’s important to understand the different types of market philosophies so that you can create your own views about the market in a logical manner.

We have listed some of the more popular market theories out there, and provided some insights into each. But this should only serve as a starting point for you. After performing the required study into this, you will come to know whether an active or passive investing style best suit your needs. This will enable you to engage in a way that best aligns with your view of the financial markets.

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