Third post of the day, wow. I'm really pouring my thoughts into this blog.
In undergrad, my professors taught strong and weak efficient market hypothesis. I went to one of them mentioning that I believed that I had found patterns in the market, and she practically laughed at me.
It seems absurd to me that academics cling to EMH like they do. Take for instance, the scenario in which an insider knows of an upcoming buyout in their company for $20 a share higher than the current market price. That insider can purchase shares all the way up to the buyout price and make a killing, beating out uninformed market participants. This example shows an instance for which the market is not efficient by illustrating how someone trading on inside information can reliably beat the market. Since only one example is needed to disprove a theory, I just went ahead and disproved EMH.
Today, I got thinking about this some more. In the movie Margin Call (watch it if you haven't seen it), the character John Tuld says: "There are three ways to make a living in this business: be first, be smarter, or cheat."
All of these edges are informational in nature!
You can be first if you run a HFT shop and front run order flow, in which case you have information about market orders.
You can cheat if you have knowledge of an upcoming catalyst that is not publicly known, like the insider trading example I gave.
I can't trade like a HFT fund and I can't cheat, which leaves only being smarter. But even that is informational in nature.
That information can be in the form of experience, allowing for stat arb trading. I know that when X, Y, Z conditions occur (e.g., a setup), there is a X% likelihood of something happening which is exploitable for positive EV.
That information can be in the form of fundamental evaluations, such as valuation models or being able to value a stock better than other participants. I may know that a stock is a fraud that is worth zero when the stock is trading at $20 due to sheer hype. I put on a short against the prevailing herd mentality.
That information can be in the form of due diligence, where I pour through SEC filings and company reports to find something everyone else missed.
Whatever your edge is, it all comes down to knowing more than the other market participants. Like in poker, we are purposefully exploiting less-informed opponents. Thus, all our edges are informational in nature. The more information we have over our opponents, the bigger our edge. In other words, our edge is maximized either by us having more (relevant) information to make decisions on, or if market participants have less information.
For this reason, it should become obvious that stocks will generally provide a much bigger edge than futures, forex, options, and anything else. The players in other markets are generally more sophisticated and knowledgeable, while in stocks there are plenty of mom-and-pop retail participants. There is also plenty of available information for stocks. You can look up company filings and websites, the short interest in stocks, other stocks in the sector, and so forth. This gives an edge to someone who does their research over lazy participants who choose not to.
This carries over to individual stocks as well. Your edge is greater in stocks for which the average participant is less informed. This is important knowledge. Once you truly understand this, you will understand that your trading results can be improved by purposefully seeking out stocks for which the inefficiency is greater. I suspect this is why a lot of the top traders on profit.ly have made their money shorting pumped up penny stocks, which is optimal for the reasons I just gave.
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