©Trading Research - www.trading-research.com - January 2015 - Author: Luca Ciolini
Today we're going to make a brief historical overview of the financial market theories; the discussion is not intended to be an academic in depht investigation, but simply a brief digression on the historical path on the subject. The goal is to understand better the foundation of the theories and their focusing in order to identify what can be useful in the designing of our daily trading methodology.
Theories are often far away from practical applications, especially because virtually no one of those who produced them has never had the need of taking daily buying or selling decisions in the markets with real money, however, the importance of these studies is that they tried in some way to standardize some behavior patterns that, even if usually far from reality, still give many useful insight for practical use.
For years, and may be academically till now, the CAPM (Capital Asset Pricing Model) has been the reference in the theory of financial markets. Without going too much in depth
into theoretical stuff we can say that beside its limits, the CAPM represent an excellent study that provides a lot of useful information for an efficient portfolio management; It is an equilibrium model of financial markets, it was published by William Sharpe In 1964 (Portfolio Theory and Capital Markets) and independently developed by Lintner (1965) and Mossin (1966).The CAPM establishes a relationship between the yield of a financial asset and its risk, measured by a single risk factor called beta. Beta measures how much the value of a security moves in tune with the whole market. Mathematically, the beta is proportional to the covariance between the security yield and market in general; this relationship is commonly represented with the security market line, shown in the chart alongside. William Sharpe, together with M. M. Miller and H. Markowitz, thanks to the CAPM studies, won the Nobel Prize in Economics in 1990.The CAPM model in summary identifies two types of risk in the purchase of a financial asset:
1) diversifiable risk: the type of risk that can be eliminated by investing in a portfolio of financial assets (eg. Mutual fund).
2) systemic risk: the risk implicit in the purchase of any financial asset, it is the market risk, which cannot be eliminated through diversification.
It then identifies (for the systemic risk) a risk premium that will be linked to the beta, ie the higher the beta, the greater the risk and therefore the expected return.
For our purpose the interested thing about the CAPM is that it is mainly based on:
-a normal distribution of the daily price range-a situation of constant market equilibrium
-all operators are always acting rationally
-assumption of perfect market efficiency (everything is instantly incorporated into prices)
-the risk is defined by the standard deviation of price distribution.
While this may be fine for a mathematical model, that means purely theoretically, it is easy to note that the market reality is very different, the balance is only temporary, operators behavior is often irrational, prices are affected by many factors, that's why other theories have been proposed such as:
BEHAVIORAL ECONOMICS: it has studied the effects of social, cognitive and emotional factors behind the decisions individual / collective and their consequences on prices, yields and optimal allocation of resources. The assumption that economic and financial decisions are taken in a perfectly rational and efficient manner is definitely denied.
Early studies started 1950 but the biggest boost to BE came, since the 70s, by the works of A. Tversky and D. Kahneman (Nobel Prize in Economics 2002)
FUNDAMENTALISM (ECONOMIC & MATHEMATICAL):it was based on the economic concept of "laissez-faire" , the economic liberalism policies according to which the market, left free to itself will offer the greatest potential for growth and prosperity for everybody, the market regulates itself; It was fully formulated by Adam Smith, who advocated a minimal interference of government in the market economy.
From here, have developed opinions against it in terms of economic policy to be more or less interventionist, protectionist and mixed.
From our perspective, more strictly on the financial side, in the fundamentalism it has been studied the effects of individual economic variables on the prices of financial instruments (equities, futures, bonds, options) with more or less complex relationships, sometimes even difficult to be matematically defined. Failing to define also all interactions between the variables themselves, a mathematical equation that defines the reality of the market, can not be written and therefore resolved; a fundamentalist solution to define the market behavior is not possible.
ECONOPHISIC: it has entered the scene in the mid-90s by focusing on the search of a distribution function of the market behavior. This theory shows that markets are often not in equilibrium and the Gaussian distribution is not able to describe the complexity of the market, which is constantly changing due to the continuous feedback from participants (traders)
The "Fat Tails" of the distributions often show that the Gaussian is not able to describe the complexity and the variability in time of the "market auction". Basically it was looking for a distribution function describing the markets, but the conclusion is that it may not exist, and I would personally add, anyone who works on a daily basis in the financial markets can only be deeply convinced of this.
MARKET VALUE ANALYSIS AND AUCTION MARKET THEORY: the one who has definitely successfully tried to put together a theoretical/scientific approach with the reality of the financial markets was a pit trader, a person who then verified "on the field" a particular theoretical approach .
This person is J. Peter Steidlmayer, the inventor of the Market Profile, it was 1985 when, commissioned by CME (Chicago Mercantile Exchange) he came to the coding of this new method of representation of the market auction that initially was intended only to members of the CME, then quickly spread outside.
The big concept innovation compared to the CAPM and the ECONOPHISIC theories, was that the primary variable becomes now the value, ie the relevance of prices around which are mainly concentrated the trades, where the price spent more time; This adds a further dimension of analysis in addition to price alone, the graphical representation is then called TPO (Time, Price, Opportunities). Later the same J.P. Steidlmayer, and also James Dalton, elaborated a series of observations based on the market profile representation to better understand the "puzzle" of the market by providing many useful insights and practical ideas for daily trading. They defined a number of concepts which together constitute what is now commonly called AUCTION MARKET THEORY.
It is an interpretation of the market as a continuous auction, with the price that advertises opportunities (like an auctioneer) and the volume that follows at each price level that measure his success or not.
(For a synthetic description of these concepts and AMT termminology, please see our GLOSSARY ).
In recent years, thanks to the increased transparency of the exchanges which now offer in real-time an increasing amount of information, and also thanks to the development of many good charting software, the use of market profile and all AMT concepts has expanded dramatically between traders
At Trading Research we actually do not use the original MP representation but we use the Volume Profile along with a price chart (candlesticks and renko); we use most of the concepts of the AMT as in our opinion it currently represent the most comprehensive approach to the market, allowing us to make some order, to put some "stakes" in an environment where everything can change very quickly for no apparent reason and above all it allows us to make decisions and develop our knowledge based on MGI (market generated informations).
Usually the majority of traders, focusing only on price, even manipulating it in the most intelligent and sophisticated way with indicators and oscillators, is frustrated in front of the daily repetition of situations where this approach does not work, and above all without being able to give themselves any explanation.
In trading "nothing works" as most of the successful trader say, but having a justification, even in retrospect (of why a support has broken, why a big movement stopped right there and then immediately reversed, or why the prices continued to fall even when the indicator was showing a deeply oversold level or again why the intersection of several moving averages didn't cause anything etc ..) definitely helps to have a more relaxed approach to the markets, a better understanding of what is happening, and with more time and experience to formulate better hypotheses on what is more likely to happen next.
The AMT helped us a lot on this regard and that's why we use it both on a daily bases to make trading decisions and also as a framework for our research aimed to a always deeper understanding of the market reality.
Theories on financial Markets, Auction Market Theory, Financial markets, Auction Market Theory