What is a Choppy Market
Choppy market refers to a market condition whereby prices swing up and down considerably either in the short term or for an extended period of time.
BREAKING DOWN Choppy Market
A choppy market can be expected when following prices and price action in a day trading scenario. Most securities will have choppy market pricing that fluctuates throughout the day. Choppy market scenarios from day to day are generally a result of efficient market pricing.
Market studies by academics and professionals have found that most regulated financial trading markets around the world operate according to efficient market theory. This theory shows that securities trading on public exchanges will primarily trade at their intrinsic market value. This value is based on advanced financial models and valuation best practices used by investing professionals around the world.
Since securities trade on the financial markets nearly 24 hours a day there is latitude for pricing to fluctuate around its intrinsic value due to the nature of exchange market making and discrepancies that can be caused by new developments affecting the trading price of a security. Market making mechanisms and daily developments affecting the trading price of a security are the two primary factors that can lead to choppy market trading scenarios.
Bid-Ask Market Making
The mechanisms that facilitate market making on financial market exchanges lend themselves to choppy market scenarios on a daily basis. The factors that cause prices to fluctuate are the same factors that can lead to choppy market trading. On a daily basis, the price of a given security will typically be influenced by many factors which can influence its price at each second.
In the financial markets, market makers are used to match buyers and sellers. An exchange can have its own market makers. It may also contract with multiple market makers to facilitate trading. In the secondary market, market makers are essential for trading because each buyer must be matched with a seller and vice versa. Initial public offerings provide some exceptions to this process but generally the majority of securities being trading are not new issuances.
The use of market makers and their procedures around bid and ask prices generally make securities market trading choppy on a daily basis. Market makers operate during the regular trading hours of an exchange. They take an intermediary position on each trade that occurs in the market and are executing trades every second. Thus, the per second execution of trades is a primary driver of choppy markets. Market makers execute at bid-ask prices on each trade. This causes securities to move by multiple cents per second and also to swing within a range of prices every day, making markets inherently choppy on a daily basis.
The mechanisms of market trading and the volume of trades placed throughout the trading day lead to efficient pricing of markets on a per second basis. However, while markets are generally believed to be efficient there are opportunities to profit from inefficiencies and new developments that lead to changes in price.
Even when profit opportunities do arise, investors must still contend with the bid-ask per second pricing of a security which is often influenced by high volumes of institutional trades. When new developments occur around a specific security, the price of that security will see more choppy market swings in its trading price. Thus, choppy market trading in a specific security or a specific market is likely for extended periods of time when investors are speculating on ongoing developments that will directly affect the price. In this type of scenario, choppy market trading can offer higher potential for profit opportunities as well as higher risks of loss.
In some cases, certain markets may be choppy over extended periods of time with no clearly defined up or down trend. However, efficient market theory shows that choppy markets with substantial profit opportunities will typically not occur over prolonged periods of time due to the innate efficiencies that are present in actively traded markets.