What is Market Inefficiency in Forex Trading Smart Money Concept SMC
In this article, you will learn what is market inefficiency in Forex trading, why it occurs, how to trade it and how it relates to Smart Money Concept SMC.
What is Efficient Market?
In order to understand the concept of market inefficiency, first, let's discuss what is the market efficiency.
The price of an asset is constantly striving to find a fair value.
A fair value is the price of an asset that provides the equilibrium between supply and demand on the market.
A fair value is weighted by the perception of the market participants based on all the news and data that is available about the asset. Simply put, that is the price that all the market participants agree about.
On the price chart, a fair value of an asset usually represents a price range. A horizontal parallel channel on a price chart where the price stuck and remains stable for a relatively long period of time.
Look at EURUSD on a daily time frame. After quite an extended bearish movement, the market stopped falling and started to trade within a horizontal range. The pair found a fair value.
According to the theory, the efficient market reflects all the information that is available about the asset in its price. Hence, in the efficient market, the price equals or almost equals the fair value.
Please, note that 100% efficient markets do not exist. It is the economic utopia. But the nature of the financial markets continuously aims to maximize its efficiency levels.
What is Market Inefficiency?
However, the surprising fundamental data, news, and rumors make the market reassess the fair value, creating an imbalance in supply and demand and making the price shift rapidly.
Such price adjustments are called the market inefficiency.
Common characteristics of the market inefficiency are high momentum candles and price gaps.
In technical analysis, the violation of one of the boundaries of the fair value horizontal ranges usually confirm the inefficiency.
Please, note that human factor also may cause the market inefficiency. The examples of such inefficiencies can be emotional decisions, wrong evaluation and assessment of a fair value.
After consolidating within a range for almost a month, EURUSD turned bullish with the release of surprisingly positive fundamental news, causing a violation of the resistance of the range and a rapid bullish movement - the inefficiency.
New Fair Value
As the market participants interpret new data, the price strives to find a new fair value.
Strongly negative news push the market lower till the equilibrium in supply and demand is established and a new fair value price is found.
Such a situation occurred on CADCHF pair. After a long consolidation within a horizontal range, where the market found a fair value, the price dropped. The violation of the support of the range and rapid bearish movement is the example of the inefficiency.
The market found equilibrium and a fair value much lower and started to consolidate again.
Alternatively, highly positive news make the price go higher, till buyers and sellers will find the consensus and a fair value, making the market stop.
Look at a price action on EURCAD on a daily. The market found a fair value and was stuck within a horizontal range for a month.
A release of strongly bullish news made the market create the imbalance in supply and demand. The violation of the resistance of the range is the example of the market inefficiency.
The price was going up sharply till supply met demand and a new fair value price is found.
Usually, the point where the market stops is a significant liquidity zone: support or resistance area.
For example, CADCHF pair found the fair value price after a test of a significant historic liquidity zone. The surpassing supply was finally balanced by a demand from there.
False Signal
Quite often, the market participants overestimate the impact of the news. The false interpretation of the data make the market quickly return to its fair value.
Look what happened on US30 index after a release of important US fundamentals. The market bounced rapidly, violating a fair value range, creating the inefficiency. However, it turned out that the market participants overestimated the positivity of the news and the price quickly returned within a fair value range.
How to Trade Market Inefficiency
Your job as a trader is to recognize the market inefficiencies because it provides profitable trading opportunities.
Price action patterns, technical indicators, candlesticks indicate potentially inefficient: oversold/overbought, undervalued/overvalued market.
Smart money concept is one of the strategies for identification and trading market inefficiencies.
After you spot the market inefficiency caused by some news or any other fact, assess its real impact. Assess the significance of the event and analyze whether the market correctly reacted to that or overestimated its impact.
Correct interpretation by the market will push the prices to a new fair value, giving you a perfect trading opportunity. While the overestimation and misinterpretation will push the prices back to its fair value, giving you a chance to profit on that.
The attack of Israel by Hamas made gold prices go up rapidly, violating a fair value range. This event changed geopolitical sentiment in the world, causing the reassessment of Gold fair value. The price went hundreds of dollars higher before it found a new fair value price.
Inefficiency is one of the core terms in Smart Money Concepts. The understanding and your ability to recognize it are essential for profitable trading.
I hope this article provided in-depth explanation.
