Candlestick Trading Blog

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Much of stock market investing is an attempt to exploit stock market inefficiency. Market timing takes advantage of short term fluctuations in stock prices. Scalping, during periods of high trading volume and great volatility, takes advantage of market inefficiency. Trading in penny stocks and low cap stocks in general takes advantage of market inefficiency because many small cap stocks are largely unknown to investors.

A large, mostly transparent, equity market such as the New York Stock Exchange (NYSE) or NASDAQ is quite efficient at assigning accurate value to stocks. With large cap stocks and mid cap stocks it is typical that a sufficient number of analysts follow the company. A sufficient number of traders and investors buy stock and sell stock in the same company. Thus its stock price times the number of shares outstanding is an accurate reflection of the value of the company.

When there is bad economic news many investors may sell their stocks in anticipation of a widespread drop in stock prices. Many companies that are doing perfectly well will see a drop in their stock price also. This market inefficiency typically corrects itself as those who engage in value investing see that the stock is underpriced and buy, driving the stock price up. Buying when a stock is unnecessarily low in price is a good exercise of market timing and takes advantage of this type of periodic market inefficiency.

When there is news that affects the perceived value of the company, such as a new product or news of a takeover bid, the price consensus will change rapidly and, often, fluctuate before it settles in to a new price range. During this time of market fluctuation and inefficiency traders can profit by buying stock and selling stock during swings of the stock price.

Both scalping and market timing take advantage of temporary, albeit repeated, situations. The lack of information about penny stocks and many low cap stocks is a constant source of inefficiency that awaits exploitation by the wise investor or trader. Although hundreds may engage in stock analysis of Cisco, Intel, and General Mills there may not be many analysts following small companies making routers, pursuing a technology that will lead to the next generation of computer chips, or a mom and pop company making instant dinners for an ethnic market. Fortunes have been made by investors who saw the promise in a new company and bought low priced stocks before they went up a thousand fold. The inefficiency in this situation is the lack of information available to the investing public, not the fact that a company is new and unproven.

Exploitation of the periodic inefficiency of the stock market has to do with value investing in the case of market timing. It has to do with understanding technical analysis and skill in using trading software in the case of scalping. Taking advantage of market inefficiency has to do with a lot of homework in the case of penny stocks and small caps. Many startups fail. Finding winners in picking stocks is an acquired skill but it mostly has to do with lots of time spent reading reports, evaluating products, market analysis, and understanding the company’s market sectors.