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

  • Micron Technology (MU) Earnings Report June 30, 2022

    Welcome to the ORATS earnings report where we scan for companies with upcoming earnings announcements, check out historical earnings information, and find a potential options trade. Read on or watch the video overview here: https://youtu.be/IDgR3FzONnI.

    By ORATS_Matt,

    • 0 comments
    • 198 views
  • Does “Managing Winners” Add Value to Short Strangles?

    Some option educators suggest short strangles have historically benefited from actively managed exit strategies. A widely popularized approach is to enter S&P 500 strangles at 45 DTE and exit at 50% of the credit received or a 21 DTE time stop, whichever occurs first.

    By Jesse,

    • 2 comments
    • 4,596 views
  • NKE Earnings Report June 27, 2022

    Welcome to the ORATS earnings report where we scan for companies with upcoming earnings announcements, check out historical earnings information, and find a potential options trade. Read on or watch the video overview here: https://youtu.be/2mtx2ja-VwQ.

    By ORATS_Matt,

    • 0 comments
    • 213 views
  • KBH Earnings Report June 22, 2022

    Welcome to the ORATS earnings report where we scan for companies with upcoming earnings announcements, check out historical earnings information, and find a potential options trade.

    Read on or watch here:

    By ORATS_Matt,

    • 0 comments
    • 280 views
  • Know How To Trade Before Making An Investment

    Everyone is searching for a way to improve their living quality. Plenty of scopes are coming to the forefront and people are grabbing the opportunities with the hope of receiving the best revenue against their investment. A share market is a place that can return the high revenue of your investment.

    By Kim,

    • 0 comments
    • 287 views
  • Implied Volatility and Standard Deviation

    1. Isn't holding a naked long call (as a result of locking in a profit or plain buying outright call) in general a bad idea? Reason I think so is because of the nature of IV: it mostly falls when the underlying is rising. So you have short theta and a big long vega moving against you.

    By Mark Wolfinger,

    • 0 comments
    • 270 views
  • Introducing a "Risk Free" Trade

    A few weeks ago, I got the following email from one of our former members: "I would like to share with you an article about "projected no risk trades" or "no risk trades". Of course I was skeptical. But when he shared the setup with me, I became intrigued. How does the following risk profile look to you?

    By Kim,

    • 6 comments
    • 1,352 views
  • What You Trade Matters

    Traders love to tell people that they can trade anything. That if you have the skills to be a trader, the specific item traded is unimportant. That may be true for some professional traders who are skilled technicians. However, it’s very different for gullible amateurs.

    By Mark Wolfinger,

    • 0 comments
    • 615 views
  • The Big Loss

    At his blog, Joey offers his perspective on the top reason that so many trader wannabes are not, and will not, become profitable traders. His post is titled: Learn to Lose Money to Make Money. Here are the Excerpts from the blog.

    By Mark Wolfinger,

    • 0 comments
    • 806 views
  • ETF Vs. Stock: Note Down the Vital Points

    Today’s small investment can fulfill your dream of high living tomorrow. But investing blindly can make it reverse. We all want to get a high return on our investment. Stocks or ETFs can be the best option for you in such cases. The investment in stocks or ETFs is not very different except few noticeable points.

    By Kim,

    • 0 comments
    • 761 views

  Report Article

We want to hear from you!


There are no comments to display.



Create an account or sign in to comment

You need to be a member in order to leave a comment

Create an account

Sign up for a new account. It's easy and free!


Register a new account

Sign in

Already have an account? Sign in here.


Sign In Now

Options Trading Blogs Expertido