The 'Efficient Market hypothesis' (EMH) was probably developed around the 1860s in france, its basic law can be summarised like this: "The share price of an entity reflects the true value. It's a sort of intrinsic value". This is often misunderstood as the liquidation value divided by the number of shares issued. It actually means the total value including non-quantifiable attributes such as the perceived value and the potential value(s) of future and current products.
The efficient market theory is often dismissed by traders because the mechanisms of buying dips and shorting peaks is seen as the only active "blunting" in the charts. (Blunting is the process of reversal or correction of a sharp trend once market sentiment shifts). Remember: EMH isn't a result of trader sentiment or arbitrary trend it's the theory which explains it.
In application the efficient market theory explains why speculation doesn't go on rampant for months or years, at some point in a trend the market will realise the price is straying too far from the 'true price' and will bet the other way (or at least close out, effectively betting the other way). When you're trading there's no real way to profit from this knowledge but keep in mind that if a company can stay solvent through a downward spin its general tendency is to return to the efficient price. If a company such as VW flogs off assets and cuts back to respond to poor market opinions this is effect the efficient price because the overall value of the company has declined along with the perceived value. This means when the price returns to the EM price it will be lower than it was before. If VW remains solvent through the tough times without compensating (which in general is impossible) its a good bet to assume the price will, within a reasonable timeframe, return to the EM price. This is why good research is vital! I know too many traders who assume that if the share price is down the intrinsic value of the company is too. Because there is no metric for 'EM price relative' (Let's call that X≦EPR. 'X' being the current market price as a result of trend and EPR being 'Efficient Price Relative) its impossible to make a good estimate as to the true EM price without some calls and emails.
To find out if 'X≦EPR' is true of the stock you're interested in build a profile of the current corporate climate by looking at recent news/leaks or anything that will give you an idea as to the response of the company at the time of 'X'
I appreciate most of you here trade equity options, generally considered to involve a lot less research and a lot more fundamental analysis - But this is a vital concept to grasp of you hope to get a good idea of what the macro market is doing. EMH applies to the consolidated stock price on any one index (as well as, to some extent, every index).
I hope this didn't get too complex for you to follow, i'd prefer to describe it all with some juicy mathematical formula but that feeling, I think you'll agree, is a #justhedgefundthing.
Submitted October 18, 2015 at 03:34AM by 432parkavenue http://ift.tt/1jN3yDK