Efficient Market Hypothesis and Trading Systems
The Efficient Market Hypothesis (EMH) is the idea that markets are informationally efficient and that all the news, data, etc is priced into the market price at anytime, hence it is impossible to make money in the market.
In finance the EMH is taught as if it is written in stone. Fortunately, I started trading before taking any finance classes, so I was skeptical of the theory. Ask any trader, the markets are far from anything resembling “efficient” and you know what? You CAN make a lot of money if you just put your mind to it, have some patience, and have the right guidance.
I have been using automated trading systems for trading the foreign currency markets since 2003. And I have been profitable.
So, what did I do?
Technical analysis. Technical analysis may sound like its complicated, but it really isn’t. There are essentially two different types of trading: fundamental and technical. Fundamental traders watch the news, read about companies (or countries in the case of forex), and make a decision based on what they feel will happen in the market. This is what Warren Buffett does and for most part and this is highly subjective and requires a lifetime of experience to do well. Technical traders on the other hand only look at the price of what is being traded (in trader lingo it is called a “security” which could be a stock, currency, commodity, or anything else).
In technical trading we don’t care what is being traded or what is happening in the news, because it doesn’t matter. If the price is going up, buy, else if it’s going down, sell. To make life easier technical traders use tools called technical indicators which help make the price movements easier to understand and predict.
Since technical trading is objective, a strategy can be tested to see if it works before you put your hard earned money at risk. For example, let’s say we think that when Microsoft (MSFT) will gain $20 once it crosses its previous 25 day high. In other words, if MSFT rises above the highest point that it reached over the previous 25 days it will rise for about $20. This means that we can construct a trading system and test it for all the historical data of MSFT and be quite sure that it will make money in the future. Once we are satisfied we can put our money to work and it will raise the chances that we will profitable in the future.
In trading, even if you are right 5% of the time you can still make money by letting you profits run and cutting your losses short. That is good trade management, but that is for another day.
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