If market is efficient, how trader equation can yield a positive EV?

When you consider commissions and fees, trading is actually a negative sum game. The profits in my opinion come from the fact that many/most people are irrational and engage in loss creating behavior. Those are the people who add money to the markets. You see Al talk all the time about things like poorly placed stops, trying to pick tops/bottoms, trading against the trend, etc. There have been many studies that show the vast majority of participants in these markets lose money to the smaller number of profitable traders.

Hi Andrew,

Since this is a theoretically example, we can ignore the commissions fees for simplify the equation. You are also right with the profit of retail traders like us - for me I am trading the CFDs, which means my profit is come from the loss of other traders who make mistake. 

I just want to think in term of the institutions. Of course the chart we see on the screen is a footprint of bulls and bears institutions. I just wonder that all institutions are smart, profitable, how can they lose the EV to other firms - have negative trader's equation. Al has explained in his book is that for example: if we target a swing trade 1:2 with prob 40%, they will take opposite prob (60%), but will help different target (your reward 2 times the risk is their loss, but they have different the target, not just achieve 1 time the risk when you are loss).

However I think that if all the firms are profitable, when who will be a loser (this is in theory for purpose of understanding the concept). I got another idea this morning is the firm who need to do the hedging for other part of their business, so they accept the "cost" of doing business.

I understand that maybe we cannot know the exact the answer and no one know, but I hope that we can discuss it as a theoretically example

Yes I agree that hedging is also a big factor in the market and a source of money added to the market.

Another reason a trader can find an "edge" is because everday a workers' retirement (retirement accounts) money enters the stock market as individuals contribute part of their salaries towards their retirement. This is relatively indiscriminately invested.

Also, I believe Al states that you dont necessarily compete with the clever traders (and algos), rather you piggy back the somewhat reliable swing patterns they help create.

Part of the answer is time frames. A trade can be a reasonable buy on one time frame and a reasonable sell on another. So a lot of the institutions that are taking the other side of your trades are profitable because the other half of their trade is different from yours.

The trouble with the question, I think, is that it assumes something out of “efficient” that it cannot mean in practice—a process completely free of waste. Well, we are specifically the ones who spot the waste in the first place and reduce it. It is a rare and productive skill, and worthwhile for the few who can do it.

In the first place, when it comes down to it, the “efficient market hypothesis” appears to me to be a truism masquerading as a falsifiable hypothesis or genuine philosophy. But I suppose it cannot be left unaddressed since it is frequently used by a handful of naysayers, first assuming it true, then using it to assert without proof that traders cannot ever be profitable. That is absurd even assuming its most broadly agreeable interpretation: that markets usually arrive at a fair balance between supply and demand extremely quickly. Who is enforcing that? Do those people not deserve payment for such a service? What happens if they are wrong—do they not then deserve to lose money? Who wins and loses if those people were not doing it?

There are real answers to all these questions. In a market system, traders do a lot (though not all) of the enforcing. They are providing the service of price insurance (whether by direct orders or through the options market), and without them, big losses would more frequently fall on end producers and consumers who don’t specialize in skilled speculation, aren’t capitalized to handle big losses, and in most cases are just trying to mind their honest business and don’t deserve big losses.

It is not a mistake that futures were separately invented in various places, yet always adjacent to agriculture—a farmer growing a crop has a lot of unknowns and farming has only rarely been a business with great profit margins. Without a guaranteed buyer, farmers can do everything right with a lot of hard work and still not be in business a year out for reasons out of their control, like a severe drop in price. Yet human civilizations will always need food; the risk will always exist, and someone will have to soak such losses eventually. Financial derivatives are just one way to insure this, but most of the other alternatives used historically have been tyranny or mere subsistence.

Many people in the academic and trading spheres view price as a puzzle to solve and not as a compromise solution to countless complex external problems. I don’t like that view. I think I should cultivate a healthy mindset about what I set my mind to. I think that we traders do serve a function to society with an unusual talent, that markets do not exist for our benefit, and when we get profits, it is only because we are contributing to the correction of imbalance. Remember, your limit order may be someone else’s stop loss, but if not for you, they would have had to cross a bigger spread.

Anyway, that’s why I feel this question deserves more than a knee-jerk response like, “No, if markets truly are efficient, they are not efficient in that way.” It was put more thoughtfully than the question usually is, so it deserves a thorough attempt at an answer. But… maybe I just like skewering the ivory tower nonsense just a little, and the short dismissive answer gives EMH too much credit 🙂