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:: ever wondered why markets
turn ?
foretelling
the future? Or calculating market probabilities? You decide.
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NOTE:- "Why Markets Turn" has been registered as a trademark by "Morikawa, Dan", the owner and operator of the website "whymarketsturn.com" on Nov 13th, 2006. This article is nothing to do with either Mr Morikawa, or his astrological software prediction method, and all trademarks are hereby duly acknowledged. To read more about Mr Dan Morikawa and his allegations of 'copyright infringement' aganst this website, click here Market Turns
caused by arbitrage
One theory of
market behaviour is the so called 'perfect market' hypothesis. This
asserts that the market is perfectly efficient, and that everything
there is to know about a stock or other security is accurately represented
in that security's price. This theory is essentially correct, except
the process suffers from lag. Not all market participants have access
to the same information at the same time, and so their understanding
of the fair value of a security may be at odds with the understanding
of other parties. For example, in the run up to the Twin Towers
disaster, it is alleged that certain terrorist groups used legitimate
facilities to short those sectors that would be hit hardest by the
tradegy, and go long on sectors that would rise from it (they bought
gold, for example, always a hedge in times of crisis). The rest
of the trading world had little idea about any of this (although
some of the more astute market makers may have spotted the movements
in those sectors and wondered what the reasons were, reacting automatically
even without the full information).
Profit arbitraging
Which brings
us to the concept of 'profit arbitrage'. As you will know, the various
market participants operate on different timescales, with day traders
and the pit itself only holding positions for minutes, swing traders
holding a few days, and Warren Buffet holding for 3,000 years. This
in itself should cause massive discrepancies in participant belief
structures (Billy Daytrader Jr only wants to make half a point before
bedtime, Buffet wants a trillion before he dies). So what 'oils
the wheels' between these disparate actors in the market? Profit
arbitrageurs. There exists a class of market participants who make
a living exploiting even tiny differences in other participant's
belief structures. A good example of this is the 'Chicago Mob' in
the pits at the S&P, who spend all day looking for variations
between the price of the big contract and the emini contract. When
they spot one, no matter how small, they can place a trade that
is effectively riskless - 5 small contracts, after all, should always
equal one full size contract. If it doesn't, then sell the overperformer
and simultaneously buy the underperformer. Guaranteed profit no
matter which way the market moves (before you get excited, you should
know that you need to be on the floor for this, with DEEP pockets
- we are talking thousands of contracts to make a decent living!)..
Predicting
Market Turning Points in the real world
So now you can
probably see the various forces that pull and tug the market every
which way, and why of necessity it is 50 - 50 whether tomorrow is
up or down. Profit arbitargeurs are totally uninterested in market
direction, but they exist purely to 'bring it back into line' when
they spot even very small misalignments. Their actions (among other
things) help ensure the randomness of the day to day moves. But
hang on - isn't it possible to construct a trading model that understands
all this, and can take account of it? Wouldn't THAT allow us to
predict tomorrow's market today? No! So what can we do? Cycle
analysis...
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