Dec

22

I am fascinated by the concept of market inefficiency. From my perspective, the concept is related to the price formation mechanism. But more educated. An inefficiency can be exploited from a trader's perspective only if it is significant enough to overcome the transaction costs. Spread, commissions, etc. can make it not tradeable. This is true especially if the inefficiency occurs in very short time frames at the intraday level.

From a speculator's perspective, a methodology should be in place:

- to identify whether a new inefficiency is created. This should allow, while monitoring the market, to spot a new inefficiency with a very low delay.

- to determine the end of an ongoing inefficiency with a minimum delay, in order to limit losses that come from continuing to trade it.

One issue I see is related to the amount of data necessary to assess and validate a candidate inefficiency. 10, 100, 1000 bars/days? This choice affects directly the delay with which a speculator spots a change in the pattern. But the length of data influences also the probability of mistakes and false assessments. The methodology to follow to identify an inefficiency should follow a scientific approach.

The market presents a behavior which is the (weighted) sum of the behaviors of all market participants. A change in behavior of one or more participants can modify the market characteristics of a specific product. This is very likely what happened since last summer after the financial crisis developed. Why the big ranges? What has changed? or better: who has changed what? I am not able obviously to answer these questions, but the change has been evident to everyone. What is the impact on existing inefficiencies? Is the new environment creating new opportunities? If yes, how to spot them? In this case the length of data to use may be easier to identify as the break with past low-range days was very clear. In other cases, it is not. The parameters to be monitored to categorize market behavior are important. I could find several great ideas on the this web site, but theoretically I lack a comprehensive and systematic view of the approach to take.

Once a pattern is identified, it is important to assess whether it is tradeable. Under specific conditions may the market behave inefficiently. One aspect is related to the validation process. How and how much does the behavior need to be "different"?

The other aspect is that this observation has to become a strategy, with proper entry and exit rules. Which makes things difficult especially when you have to find adequate exit rules in case the pattern does not work out as expected, heavily impacting returns in some cases.


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