50: Is The Stock Market Random Or Predictable? The Final Debate On Efficient Markets

Show Notes: http://optionalpha.com/show50

One of the foundational elements of my personal trading style with options is the belief that the stock market is random. Random meaning that we can't gain an edge picking a direction. And for years, this assumption has been more or less accepted by the public and academia.

In the last couple months, the theory or hypothesis around random financial markets has repeatedly been challenged, which is a good thing. A countless number of people have tackled the issue and published their findings on random market behavior. I wish I could link them all up here, but it's just not possible nor realistic. Therefore, my goal on today's show is simply to present what I believe to be the best research on the topic of market efficiency and predictability.

Admittedly, I scheduled this show as a follow-up to Show 49 where we backtested 15 different option buying strategies during the last market crash. And the reason is that I wanted you to recognize how much "perfect timing" had an impact on the results of that case study. In Show 49, we only backtested the put buying strategies for two years assuming you were 100% right in calling the impending market crash.

If you expanded the timeline out to 3 years on either end - i.e. you're not a market wizard and can't time the crash precisely, then each and every scenario lost money. In fact, each backtested put buying strategy only made money during Sep & Oct of 2008 at the height of the collapse. During all of 2007, you would have lost on average 56% of your capital waiting for the crash to happen.

Be honest with me now; how likely is it that you would have actually held through a 56% drop in your account balance before you called it quits? And that was assuming you had near perfect market timing! Still, the traders who sold options didn't try to time the market, eventually won. Sure, they may have experienced a draw down in 2008 if there were not positioned correctly, but even still they would have made money trading through the crash.

As you listen to the show, I want to challenge you to ask yourself the following pressing questions about investing; Is the stock market random? If it is, why should we care so much about picking a random direction? If it isn't, and indicators are present to predict future moves, can I even uncover the non-random patterns? How much time or money would it take to profit under the assumption of randomness vs. non-randomness? What trading strategies fit my personal style the best?