Monday, November 14, 2016

Market Efficiency and Trading With Market Cycles

Above is a real time screenshot of the ES futures, with 15-minute bars.  It's a nice chart, because it illustrates an important trading principle:  that of the efficiency and inefficiency of the market's price behavior.

In an efficient market, a given amount of buying or selling activity yields a significant degree of price change.  In an inefficient market, a given amount of buying or selling activity leads to relatively little price change.  

Think of an idealized market cycle.  At the peaks and troughs, we have topping and bottoming activity.  Notice, for instance, the bottoming of the ES market at the left hand side of the chart and the topping on the right.  At market turning points, we have selling and buying activity, but now that selling and buying finds interest on the other side.  That leads to back-and-forth movement that comprises the bottoming or topping of the cycle.

Between these bottoming and topping processes, we see rather efficient market behavior.  The buying in the middle of the chart moves prices relatively steadily higher.  These cycle dynamics occur across multiple time frames, including intraday as noted above.  For an example over a long time horizon, think about the SPX market during 2007 and early 2008 (topping) and late 2008 to early 2009 (bottoming), with efficient selling between the two and efficient buying afterward.

These cycle dynamics help to explain why trading is so challenging.  During those transitional times of topping and bottoming (inefficient markets), fading strength and weakness will work as a strategy.  During the efficient periods, we want to ride trends.  If we understand cycle dynamics and can assess the transitions between greater and lesser efficiency, we're in a stronger position to adapt our trading to the supply/demand situation of the marketplace.

It's when we're locked into a single mode of trading, whether it's "mean reversion" or "trending", that we court frustration, as we're ill-prepared to trade with market cycles.  As I've noted in the past, if we're going to dance with the market, we have to let it lead; otherwise, we'll find ourselves in a ballroom waltz when the music turns hip-hop.

Further Reading:  The Dynamics of Stock Market Cycles