We could say that a freely traded market is in the business of digesting
information and rendering it useless. It's an organism for metabolizing
information, and as with any organism, once it has metabolized its food,
that food is no longer useful to it.
In the case of a free market, the information that the market seeks can only
come in the form of buy and sell orders. The market has no other way of
receiving any information.
An example. Let's say that a hundred people in the world know that a severe
draught is going to affect the price of coffee next month, but that they
have told no-one else and also have done no buying or selling based upon
what they know. Does the coffee market "know" this information yet? No, it's
completely unaffected by it.
Only when some person or institution starts buying or selling based upon
that information can the market begin to receive it, and the more people or
institutions who do so, the more the market can be said to "know" this
particular piece of information.
When that piece of information is widely known among those who participate
in that market, and corresponding long or short positions have been taken
based upon it, then the market can be said to have fully digested or
discounted the information available up to that moment, and it is no longer
possible to make a profit based upon that information, unless the
information changes.
At that point the information may be fascinating and even accurate, but it
is no longer possible to make a profit upon the information, simply because
a market has no way of distributing free money to those who don't possess
some food that the market hasn't digested yet.
Only if one possesses information that most other market participants don't
know yet does the potential of a profit based upon that information exist.
This may seem obvious, but it is violated frequently in practice by many
traders, as we'll see.
Of course, one can always make a profit by luck or accident, but trading
that is profitable long-term cannot be based upon the whims of luck for
obvious reasons.
********
Basically, there are two types of information available to a free market.
The first type is what is called "insider" information. If you know that GM
is going to raise its dividend next month, and this is not public knowledge
yet, you could profit very well through your inside information. However,
profiting from this type of information is illegal in most countries.
The second type of information occurs if you can usefully analyze a market,
from public information, in a way that only a few market participants know
about. In this case you would also have "inside" information, but in a way
that is legal and usable.
The error comes when we acquire some system or method of approaching the
markets that is widely marketed and available. No matter how adroit the
system or approach may have been, as it is more widely marketed and
available to market participants, its consistent profit potential must go
down, because the market is increasingly digesting this information.
As a market increasingly digests a particular way of analyzing or
approaching that market, the method becomes more and more ineffective for
purposes of making a profit. It may still be useful in an academic sense, or
as a subject of intellectual fascination, but it must become less and less
satisfactory as a profit-making engine because it has the same limitations
of life-span as any other "insider" information that is beoming public
knowledge.
What usually happens is this: Gann or Elliot or some other brilliant analyst
comes up with a theory or set of theories that look at markets in a new way,
the newer and more radical the better (because the less like other systems
that are known by the market). And with this new approach the analyst makes
successful profits or predictions.
At length he (or she) publishes the theory, but its knowledge and acceptance
into the marketplace is slow at first. It is simply not very widely known
yet, and for that very reason its profit-making potential continues, though
slightly diminished because it is known by a few more participants.
As time goes on and the theory becomes more widely known, though, its
profit-making potential goes down even though it continues to make
predictions that sometimes are fulfilled. What happens is that the
predictions become more "sloppy" on average.
If a turn, say, is predicted for such-and-such a date, the turn might come
earlier than it otherwise would as more participants take positions
anticipating the turn. Or the turn might become more rounded instead of
angular. Or it could become sloppy in other ways.
In any event the profit potential goes down on average as the market is
increasingly in possession of this information. Any particular turn or
prediction, of course, for various reasons could be as accurate as before,
but the predictions on average become less amenable to making profits.
Finally the theory becomes very widely accepted and acclaimed, and
ironically, it is just at this point that the theory stops making money on
average for participants. Particular participants or predictions may get
lucky, but in general the system or approach is much less effective.
As time goes on, even though the theory or approach is widely acclaimed,
participants who are alert begin to notice that they are not making money on
average using this approach. In fact, they begin to have losses using it
because the market can see them coming.
And as this becomes slowly known, the theory or system becomes less popular
and is slowly discarded by more and more people. Finally it becomes
relegated to the dust-bin of market history, interesting perhaps, but
discredited or irrelevant.
As this happens, its profit-making potential begins to pick up again and the
few participants who are using it begin having some good successes. And they
tell their friends or associates-and the cycle starts all over again.
But not quite. Instead of oscillating back and forth between popularity and
unpopularity, that is, between non-profitability and profitability, the
system or method usually settles into a kind of symbiosis with the market,
whereby those participants who are using it make on average neither profits
or losses.
And that, of course, means that they're taking losses on average, because of
transaction costs, bid-asked spreads, and other sources of friction against
profits. Yet the approach still has some successes and these are widely
touted, and so the game continues.
********
How, then, should an investor approach the issue of market theories, systems
and approaches? In my opinion, the only way to stay ahead of the market's
digesting of information and rendering it useless is to partially develop
your own system.
That way, the market has no way to know about your "insider" information
until you choose to tell your friends about it or sell it or disseminate it
in some way. The exception to the above comes from your own buying and
selling in that market, but presumably that is a small fraction of the
market's activity. To that end, this book endeavors to acquaint you with
some novel and hopefully penetrating approaches to free markets, and then in
each chapter give some suggestions as to how you might want to explore from
there in your own investigations.
Because, unless you come up with some approach to markets that is at least
partially unique to you, the market in some sense will already "know" what
you are doing and thus tend to deny you consistent profits.
No comments:
Post a Comment