An intuitive way of understanding the nature of PRICE DISCOVERY
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This is an idea that I have an probably will keep working on for a long time. I haven't shared any ideas in a while, and this idea will be a detailed and one of my best ones so far. The aim is to provide the guidelines on how to improve the decision making of your next trade or investments. I will try to keep it as simple and short as possible. As the chart above is mostly explained, I will focus on other complementary explanations. The idea is based on well known decision tree methods, however what most textbooks do not state is how should they be effectively applied in practice. The diagram is a visual representation of the methodology.
A snapshot of the idea that is not altered by the tradingview frame dimensions.
The most essential rule or the truth is that almost all of asset pricing is based on guess work, as markets are forward looking. However, guesses can differ by the amount of information that they hold. Consequently, the aim is to come to the most educated guess about the paths that the future prices could take, which may not simple be the most probable outcome (i.e optimization doesn't work as intended, because markets are not always rational). To come up to the best guesses, an understanding of the price discovery process is essential. Price discovery is related to the timing and efficiency of updating of investors expectations, which in theory should be immediately reflected by the ensuing price action.
Following this train of thought, I decided to formalize the ideas that I already had from my experience of following the markets. The best way to understand new ideas is always with the help of examples:
To further explain the steps, few complementary things must be elaborated:
1. Firstly, are you investing or trading? For trading purposes only trade(speculate or bet) based on your beliefs of the probability of an event. Whereas, for investments consideration of a multitude of events that are usually codependent is almost always required. For a more refined investment process, see CFA's investment policy statement (IPS) guidelines. Generally, more complex decision trees are required for investments, and only simple trees are required for trading. For options this is a relatively given due to the option maturity, although such a choice of a timeline is actually contained in the choice of maturity and strike.
2. When you are distinguishing the timeline of the events, it is of crucial importance that the events are likely to occur in your holding period horizon. For instance, there are all these talking heads such as Peter Schiff and the likes that have been blabbering about the collapse of the monetary system for the past 10 years, which is obviously inevitable (at least from a historical stand point). However, if you are planning to hold gold or bitcoin in the next year, there is almost zero percent that such an event would take place, in which case there is a mismatch between your holding period and the event that you are trading(speculating) on. The idea here is, do not come too early to the party.
3. Catalysts hold the same meaning as in a chemical context, but only now instead of substances, they are events that can speed up the pricing of certain events. They are usually unanticipated by the broad market players, hence the swiftness of the corresponding market reaction. Catalysts are in a sense hitting the jackpot, the fastness and easiest money can be made if the trade is based on such catalytic events. Given that catalysts are by default unanticipated events they are to be separately considered and not part of the diagram above. Catalysts are similar to the concept of swans from Taleb, although he focuses on events of high impact magnitude.
4. Here is a simple example of other slightly more complex variation of decision trees.
The basic idea here is to consider the timeline of the price discovery process of each event, it's conditionality to other events and whether it is a part of a cycle.
To conclude this idea, it is important to know the timelines of events and their conditionality to other events. The probability and values of their outcomes are mostly a guess work, where probabilities are usually extracted from the observed prices. So in this respect just have an idea of potential targets outcomes in each scenario which usually can be done from a historical perspective, other comparable transactions, or using technical/trend patterns. By knowing the targets, you can estimate whether the trade or investment is worthy according to your risk appetite. Likewise, if you reckon that the probability of an event is different than the priced in probabilities of the market, you are also in a position to earn nearly riskless profits, assuming the market is wrong and you are right.
Each market has its own specific price dynamics, stocks are valued using different methods (DCF, comparable ratios, etc..) to commodities, bonds or currencies, but overall it is best to focus on a particular segment. The eternal problem here is that you might miss out on opportunities that arise in other markets, especially in periods that are not volatile. Overall, all methods are based on certain set of unavoidable assumptions, even quantitative methods such as simulating price paths (media.springernature.com/lw685/springer-static/image/art:10.1007/s40096-018-0267-z/MediaObjects/40096_2018_267_Fig3_HTML.png) are at least based on an assumed drift or the distribution parameter of the residual term (depending on the model used, which is by itself a biased choice). An additional disadvantage to such methods and the use of technical patterns is that they do not consider other "soft" public or private information that is an integral part of discretionary fundamental strategy. This is why a combination of methods with choices that are rightly justified is the most consistent way to break out of the zero sum game.
Clearly many books have been written on this subject and this idea can go on in extreme details, however for now I reckon that all the principal points are covered in this idea. Thank you for taking the time to read!
-Step_ahead_ofthemarket
________________________________________________________________________________________
>>I do not share my ideas for the likes or the views. This channel is only dedicated to well-informed research and other noteworthy and interesting market stories.>>
However, if you'd like to support me and get informed in the greatest of details, every thumbs up and follow is greatly appreciated!
Disclosure: This is just an opinion, you decide what to do with your own money. For any further references or use of my content- contact me through any of my social media channels.
A snapshot of the idea that is not altered by the tradingview frame dimensions.
The most essential rule or the truth is that almost all of asset pricing is based on guess work, as markets are forward looking. However, guesses can differ by the amount of information that they hold. Consequently, the aim is to come to the most educated guess about the paths that the future prices could take, which may not simple be the most probable outcome (i.e optimization doesn't work as intended, because markets are not always rational). To come up to the best guesses, an understanding of the price discovery process is essential. Price discovery is related to the timing and efficiency of updating of investors expectations, which in theory should be immediately reflected by the ensuing price action.
Following this train of thought, I decided to formalize the ideas that I already had from my experience of following the markets. The best way to understand new ideas is always with the help of examples:
To further explain the steps, few complementary things must be elaborated:
1. Firstly, are you investing or trading? For trading purposes only trade(speculate or bet) based on your beliefs of the probability of an event. Whereas, for investments consideration of a multitude of events that are usually codependent is almost always required. For a more refined investment process, see CFA's investment policy statement (IPS) guidelines. Generally, more complex decision trees are required for investments, and only simple trees are required for trading. For options this is a relatively given due to the option maturity, although such a choice of a timeline is actually contained in the choice of maturity and strike.
2. When you are distinguishing the timeline of the events, it is of crucial importance that the events are likely to occur in your holding period horizon. For instance, there are all these talking heads such as Peter Schiff and the likes that have been blabbering about the collapse of the monetary system for the past 10 years, which is obviously inevitable (at least from a historical stand point). However, if you are planning to hold gold or bitcoin in the next year, there is almost zero percent that such an event would take place, in which case there is a mismatch between your holding period and the event that you are trading(speculating) on. The idea here is, do not come too early to the party.
3. Catalysts hold the same meaning as in a chemical context, but only now instead of substances, they are events that can speed up the pricing of certain events. They are usually unanticipated by the broad market players, hence the swiftness of the corresponding market reaction. Catalysts are in a sense hitting the jackpot, the fastness and easiest money can be made if the trade is based on such catalytic events. Given that catalysts are by default unanticipated events they are to be separately considered and not part of the diagram above. Catalysts are similar to the concept of swans from Taleb, although he focuses on events of high impact magnitude.
4. Here is a simple example of other slightly more complex variation of decision trees.
The basic idea here is to consider the timeline of the price discovery process of each event, it's conditionality to other events and whether it is a part of a cycle.
To conclude this idea, it is important to know the timelines of events and their conditionality to other events. The probability and values of their outcomes are mostly a guess work, where probabilities are usually extracted from the observed prices. So in this respect just have an idea of potential targets outcomes in each scenario which usually can be done from a historical perspective, other comparable transactions, or using technical/trend patterns. By knowing the targets, you can estimate whether the trade or investment is worthy according to your risk appetite. Likewise, if you reckon that the probability of an event is different than the priced in probabilities of the market, you are also in a position to earn nearly riskless profits, assuming the market is wrong and you are right.
Each market has its own specific price dynamics, stocks are valued using different methods (DCF, comparable ratios, etc..) to commodities, bonds or currencies, but overall it is best to focus on a particular segment. The eternal problem here is that you might miss out on opportunities that arise in other markets, especially in periods that are not volatile. Overall, all methods are based on certain set of unavoidable assumptions, even quantitative methods such as simulating price paths (media.springernature.com/lw685/springer-static/image/art:10.1007/s40096-018-0267-z/MediaObjects/40096_2018_267_Fig3_HTML.png) are at least based on an assumed drift or the distribution parameter of the residual term (depending on the model used, which is by itself a biased choice). An additional disadvantage to such methods and the use of technical patterns is that they do not consider other "soft" public or private information that is an integral part of discretionary fundamental strategy. This is why a combination of methods with choices that are rightly justified is the most consistent way to break out of the zero sum game.
Clearly many books have been written on this subject and this idea can go on in extreme details, however for now I reckon that all the principal points are covered in this idea. Thank you for taking the time to read!
-Step_ahead_ofthemarket
________________________________________________________________________________________
>>I do not share my ideas for the likes or the views. This channel is only dedicated to well-informed research and other noteworthy and interesting market stories.>>
However, if you'd like to support me and get informed in the greatest of details, every thumbs up and follow is greatly appreciated!
Disclosure: This is just an opinion, you decide what to do with your own money. For any further references or use of my content- contact me through any of my social media channels.
注释
It is important to note that recently there have been arguments that the price discovery process is no longer as it used to be, due to the dominance of the FED with its balance sheet expansion, i.e that the only thing that matters is liquidity, however price discovery as a framework in a long-term perspective goes beyond what the FED does. At some point there will be a reckoning with economic fundamentals that can no longer be driven by perpetually rolled over credit and helicopter money.注释
It seems that there are some questions about the methods. What I have to allude to is that it may seem complex until you understand the basics of binomial pricing models (see ex. investopedia.com/terms/b/bin...).When it comes to the application, what it is important as I suggested in the idea, it isn't always useful as a rule to be always applied, markets don't simply work this away. Practically, all trades and investments have their own subjective/idiosyncratic factors that make them unique. The method and the diagram, outline a way of thinking (I can't emphasize this enough), which most financial professionals use as a heuristic. In short, know what's priced in already (the past), know how the future is priced in the present (the probabilities and target values for each outcome), know the timeline of events and their conditionality on each other, and understand the match between your holding horizon and the events horizon.
Thank you everyone for the feedback and for taking the time to read the idea!
注释
Likewise, for anyone that has any questions or a ideas to discuss, please let me know in the comments here or just send me a message.
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