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Many Wall Street professionals will tell you that they can predict future stock market shifts. They might claim to use complex algorithms or advanced technical indicators to determine future stock prices. While they may be right occasionally, we believe that such prediction is fundamentally an act of guesswork, and that it is in fact impossible to accurately and consistently forecast stock price movement.
This doesn’t mean we can’t make money trading; in fact, by operating on the idea that stock price direction is random, we improve our chance for success. Let’s walk through how this works using the random walk theory and efficient market hypothesis.
The random walk theory was popularized in the 70s by Burton Malkiel, a professor at Princeton University. He theorized that stock prices move randomly and daily stock price moves are independent of each other. Under this theory, past stock price data cannot be used to predict future movement.
If past stock prices don’t predict future prices, no one can reliably make money by trying to predict future stock moves. Malkiel even postulated that a dart-throwing monkey could do just as well picking stocks as a sophisticated Wall Street investor.
We can observe this theory in action using historical data. The stock market generally follows a normal distribution in which most returns fall within one standard deviation of the mean (average).
This graph the daily percentage change of the S&P 500 all the way from 2000 to 2018. This horizontal axis shows that the average daily change (in %) in the stock price is centered at zero, while the vertical axis shows the number of occurrences of that particular stock price change. This graph shows that stock prices on average are equally as likely to go up 1% as they are to go down 1%.
Traders who still believe they can predict direction are often ignoring or missing the efficient market hypothesis, an offshoot of the random walk hypothesis. Eugene Fama and Kenneth French, two lecturers at the University of Chicago, first postulated market efficiency in the 70s.
According to the efficient market hypothesis, all relevant public information is already reflected in the price of the stock; it is therefore impossible to “beat” the market. In other words, you get what you pay for. News, fundamental analysis, technical analysis, and historical prices are all already reflected in the stock’s price.
If this is true, it’s impossible to use market timing or public information to make better returns than the market as a whole. All stocks are priced fairly, which means that you cannot cheat the market by buying an undervalued stock. The only way you could achieve higher returns than the overall market is through chance or through taking on higher risk.
For example, you might do some research on a company’s macroeconomic trends and conclude that the company will have a profitable year based on that information. You might be correct, but since everyone already knows the same things you do, the current market price will already be higher to reflect that information. If you buy that stock, you are paying exactly what it is worth, not less, given all public information.
The Efficient Market Hypothesis remains controversial. For example, there are a couple of investors who have famously beaten the market by picking stocks. You may be questioning whether anyone could do the same: after all, if they are able to do it, why can’t we?
It’s important to remember that there are thousands of investors trading at any point in time. Due to sheer randomness, someone is bound to pick all the right stocks at the right time. Those success stories are the only stories you hear. What you don’t hear are the stories of the vast majority of stock-pickers, whose returns are much less enticing.
We believe that the evidence supports the efficient market hypothesis. The U.S. stock market is currently worth upwards of $30 trillion. With so much money chasing excess returns, it makes sense that every last bit of information would already be factored into the stock price.
At first glance, it might sound as though efficient markets would make it impossible to see reliable profits when trading options. However, efficient markets are actually an essential prerequisite for establishing our edge.
First, we know we can get fair prices on our options trades. Unlike real estate markets, in which there may only be a handful of buyers for any one house seller, the stock and options market has thousands of participants. The sheer number of traders trying to find an edge ensures that stocks will be priced fairly.
Secondly, we can use probabilities to make educated trading decisions. Rather than guessing individual future stock prices, we can use historical data to align market probabilities to our advantage. Without accurate options prices, our edge in the probabilities would also be inaccurate.
The random walk theory and efficient market hypothesis together suggest that it’s not possible to predict future stock price directions. According to these theories, stocks change randomly and are priced fairly given all relevant public information. Randomness and efficiency might seem like problems for options traders at first, but are actually necessary prerequisites for successful options trading. Since much of our edge in options trading relies on implied volatility and calculating probabilities, it is important that these numbers are accurate. Efficient markets ensure that this is the case.
If this explanation why the stock market is unpredictable, let us know in the comment section below!
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