SteadyOptions is an options trading forum where you can find solutions from top options traders. TRY IT FREE!

We’ve all been there… researching options strategies and unable to find the answers we’re looking for. SteadyOptions has your solution.

What is Efficient Market Hypothesis (EMH)


Most traders have heard of the efficient market hypothesis (EMH) and most believe they know what it means. In a nutshell, it is a belief that the market is “efficient” and that the current price of shares is a reflection of efficiency. Right? Wrong.

EMH is more complex than the efficiency of the overall market, in spite of its title. Anyone who has traded stock after an earnings surprise, an unexpected merge announcement, or a major scandal, knows that efficiency does not always imply. In fact, in the short term, the market is exceptionally inefficient.


So exactly what does EMH mean?


The hypothesis states that you cannot beat the market because efficiency causes share prices to immediately take into account all known information about the company and its stock.


That definition is pretty straightforward and seems to settle the question. If current stock prices are efficient and do reflect all known information, this means that all pricing is fair and inclusive, and there is no such thing as a bargain-priced stock or an overpriced stock.


Once again, anyone who has traded in the market knows that, indeed, bargain pricing and overpricing do exist. So where is the disconnect?


The advanced understanding of EMH reveals the truth. Assuming the theory is correct, all known information is reflected in the current price of stock. But is that “efficient?”
 

What is efficient (again, assuming you accept the theory as correct) is the immediate reflection of all known information. This includes all known information, whether true or false. So in the efficiency of the market, rumors, gossip, and false information is all rolled into the same “efficiency” as the accurate information.

Image result for emh efficient market hypothesis
 

So as a first observation, the market is not efficient, although the inclusion of all information is efficient. This is not comforting considering how much questionable and downright false information is floating around in the market.


The second observation is in how the market reacts to all known information. Here you find exceptional inefficiency. For example, a stock’s price reacts immediately when earnings surprises occur, whether positive or negative. The price might move many points when even a small surprise occurs. So the knowledge about the warnings surprise is taken into the price immediately, but the market does not always react efficiently.


Everyone will agree that for a $40 stock, missing earnings by two cents per share is not a big deal; but how often have you seen a stock’s price drop 10% on the day of the surprise? You probably have seen this often. The price tends to retrace back into a more reasonable level within a day or two, so everyone knows the overreaction to an earnings surprises usually is short-term in nature.


This means that the short-term market is efficient in the speed of folding known information into price, but inefficient in how price moves in reaction. Recognizing this more important inefficiency does not destroy the EMH at all, it just defines it more accurately.


In fact, recognizing the short-term inefficiency of the market points to the timing for smart contrarian trading. Knowing that markets are highly inefficient in the short term enables you to time trades expertly.


The efficient market hypothesis is significant when talking about how information immediately affects the price per share; but it pays to also recognize an overreaction to all news (true and false) and to understand that even accurate news is subject to overreaction.


That is hardly efficient.

Michael C. Thomsett is a widely published author with over 80 business and investing books, including the best-selling Getting Started in Options, coming out in its 10th edition later this year. He also wrote the recently released The Mathematics of Options. Thomsett is a frequent speaker at trade shows and blogs on his website at Thomsett Guide as well as on Seeking Alpha, LinkedIn, Twitter and Facebook.

What Is SteadyOptions?

Full Trading Plan

Complete Portfolio Approach

Diversified Options Strategies

Exclusive Community Forum

Steady And Consistent Gains

High Quality Education

Risk Management, Portfolio Size

Performance based on real fills

Try It Free

Non-directional Options Strategies

10-15 trade Ideas Per Month

Targets 5-7% Monthly Net Return

Visit our Education Center

Recent Articles

Articles

  • Investing in Private Companies

    It is axiomatic that the largest investment returns typically come from investing in private companies. Peter Thiel initially invested $500,000.00 in Facebook, which was worth over $1b when he cashed out.  Eric Lefkofsky turned an investment of $546 (that’s not a typo) into $386m in cashed out payments.

    By cwelsh,

    • 0 comments
    • 57 views
  • Option Strikes and Expirations – What's Next?

    Options expiration dates and strikes are among the most important parameters options traders must consider. Today we have the well-known weekly, monthly, cyclical, and LEAPS options. A lot of choices. But is that as far as we can go? The realm of possibilities could be endless. Consider some of these possible expansions:

    By Michael C. Thomsett,

    • 0 comments
    • 155 views
  • Buying Deep Out-Of-The-Money (DOTM) Options

    “Income” trading has become wildly popular for option traders since the global financial crisis. This style involves selling out-of-the-money options to a hedger and collecting the full premium payment at expiry — assuming the underlying doesn’t trend too hard in one direction.

    By Tyler Kling,

    • 0 comments
    • 435 views
  • The ABCs of QE And QT

    Is QE money printing or is it something else that appears to be money printing? Search the internet for “QE and money printing”, and you will see countless articles explaining why Quantitative Easing (QE) is or is not money printing. Here are a few articles that we found:

    By Michael Lebowitz,

    • 0 comments
    • 130 views
  • A Case Study in SPX Put Writing

    I've written about writing puts on multiple occasions, as I find it to be an attractive way to gain long exposure to the underlying asset class. It doesn't have to be a decision of one vs. the other (meaning, is it better to sell puts or own the underlying asset directly?), as there are advantages and disadvantages to both.

    By Jesse,

    • 0 comments
    • 223 views
  • 10 Tips: Trade Options Like a Pro and Keep Your Day Job

    Do you feel you don't have time to trade options?  This is one of the most common objections I hear from potential traders. In this article I'll give you 10 actionable tips to trade options like a pro while you balance life's other commitments.

    By Drew Hilleshiem,

    • 0 comments
    • 578 views
  • Straddles - Risks Determine When They Are Best Used

    Risk all too often is defined by the attributes of a strategy, and nothing more. However, the circumstances under which a position is opened is a better indicator of actual risk. Why? Because risk is not fixed but varies based on proximity of price to strike, and of strike to resistance or support.

    By Michael C. Thomsett,

    • 0 comments
    • 349 views
  • 4 Directional Options Trading Strategies

    Some Option traders prefer to trade mostly non directional strategies, while other option traders prefer to trade directional strategies.  Well, in the world of Options trading, there is no right or wrong answer. You can create a host of strategies based on your preferences and outlook.

    By Kim,

    • 0 comments
    • 499 views
  • Digging Deeper into the Inflation Threat

    Stoking the Embers of Inflation is one of the more important articles we have written. The Monetary Equation Identity discussed in the article provides a counterintuitive way to think about inflation. It took us a long time to accept that this identity lays out a real case for stagflation.

    By Michael Lebowitz,

    • 3 comments
    • 1,185 views
  • Does Option Selling Have Positive Expected Returns?

    Academic research refers to the persistent phenomenon of ex-post implied volatility (IV) exceeding realized volatility (HV) as the Volatility Risk Premium (VRP). As it applies to option premiums, this leads to a positive expected return for being a systematic option seller.

    By Jesse,

    • 0 comments
    • 649 views

  Report Article

We want to hear from you!


There are no comments to display.



Your content will need to be approved by a moderator

Guest
You are commenting as a guest. If you have an account, please sign in.
Add a comment...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoticons maximum are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

Loading...

Options Trading Blogs