A market is said to be inefficient when it provides consistent opportunities for profits.
- When an asset is trading at different prices on 2 exchanges, that is a market inefficiency.
- When you are able to use satellite images of corn market to predict future harvests, that is a market inefficiency.
- When you can find order patterns to tell when a bank needs to buy an unusually large amount of Apple stocks today, that is a market inefficiency.
Difference between Market Inefficiencies and Luck
In a game of blackjack, making money in one hand does not mean you have found a consistent way to make money. You might lose more in the next 3 hands.
Similarly, making money off one trade does not mean you have found a market inefficiency.
Checking for Market Inefficiency
There are 2 ways to check if you have found a market inefficiency.
Method 1) Break it down to first principles
This means to question your decision until you reach the base rationale/assumption.
Our aim is to find a clear cause and effect.
If X happens, Y should happen. If Y doesn’t happen, we do Z to profit.
Method 2) Make consistent profits
When you cannot identify a clear cause and effect because there is too much uncertainty, use consistent good performances as an indication of market inefficiencies.
Links to Complicated Explanations
- Algorithmic Trading Strategies