Please note that the opinions expressed by the author in this article do not constitute financial advice and are solely for educational purposes only. When buying shares, the value of your investment may go down as well as up and you may get back less than you invest.
Market efficiency measures the speed, cost, and fullness in which the prices of financial assets reflect information; an efficient market should “fully reflect” available information in the asset price. With quicker and less costly information, and if more fullness of information is priced in, then market efficiency will increase. The main characteristic for market efficiency is information.
The fundamentals of market efficiency and arbitrage opportunities
There are three information sets considered when discussing efficient markets:
- historical prices (weak-form efficiency)
- publicly available information (semi-strong-form efficiency)
- private information (strong-form efficiency)
The second set is the most utilised information set (you can think of the sets as building on one another as you go down the list) with the third sometimes being used- however this third set is illegal to use as it is considered ‘insider trading’. So, as the second set is most commonly used, the market is not perfectly efficient (as only the first and second sets are being used) and so arbitrage opportunities exist in the market; a market with no arbitrage opportunities is efficient (all information sets are used) and one with arbitrage opportunity is inefficient (not all information sets are used).
These arbitrage opportunities entail a potential trading strategy with abnormal returns, and this is how many large financial institutions generate huge profits. These secretive algorithms have been more exposed recently but remain highly secretive. Sergey Aleynikov, a former Goldman Sachs VP, was charged with the alleged theft of thirty-two megabytes of proprietary trading source code just before leaving the company. This code was designed as a part of the high frequency trading programmes that ‘generate many millions of dollars of profits per year’ for Goldman Sachs. This case was followed by similar thefts at UBS, and revelations on security measures intended to protect ‘coded secrets’ at Citadel Investment Group.
Market efficiency today
Onwards from the 90s, with new information technology available, the rise of algorithmic trading has completely transformed financial markets; high-frequency algorithmic trading accounts for fifty to sixty per cent of daily trading volume in the US stock market; the implementation of algorithmic trading has improved market efficiency but what does this mean for the retail investor?
Most retail investors do not implement algorithmic trading strategies, and so miss out on the already diminished arbitrage opportunities available (the rise in algorithmic trading has devoured arbitrage opportunities quickly) and it is common to use historical price data to develop trading strategies based on ‘trading rules’.
It is likely that the transactions of retail investors contribute rather a lot to inefficiency in the market; through herding behaviour and misinformation, they can create noise in the market. This inefficiency creates arbitrage opportunities which arbitrageurs (usually large financial institutions) capitalise on. Some retail investors can get lucky and exploit these opportunities too- though most do not.
Misinformation is perpetuated (through direct/indirect funding) by many profiting large financial institutions in the market such as funds, brokerages, trading platforms, and investment banks. This leaves retail investors misinformed and losing billions of dollars each year in the market to arbitrageurs and a few (lucky) retail investors. This is the reason why CFDs have been regulated and even banned in some countries.
Ultimately, misinformation is spread aggressively amongst retail investors who then repeat the same mistakes, or lead others into the same pitfall; this can be avoided if retail investors took more time to learn about the market structure, and if more accurate information was available to supersede the misinformation spread in the retail trading community. If you are interested in retail trading, consider this information when developing your trading strategy.