Market Noise and Noise Trading
In finance, the word noise does not literally refer to unpleasant loud sounds that disturb the peace.
It broadly refers to a situation whereby there is a misrepresentation of underlying market activity.
The word was first used by Fischer Black. He made an observation that some trading in the market was largely influenced by noise as opposed to factual information. Thus, in a more narrow sense, we can say it refers to the stock market activities that are undergoing but not really reflecting the true picture of the market.
Hence the reason as to why it is referred to as market noise. These activities could include the payments of dividends or even some form of program trading, the rise of stocks or downtrend of stocks.
Traders who trade by noise typically make moves and decisions after they have heard news concerning the upward or downward movement of stocks by word of mouth, specifically in the grapevine.
They are quick to react to this news without carrying out any fundamental analysis to ascertain the validity of the news. They are reluctant to establish the actual situation of the stocks in the market. This type of traders are called noise traders. They can actually be said to be trading the market noise.
Noise traders, in most, cases act the way they do because they do not have the fundamental information concerning particular stocks and securities. The reason as to why they do not have this information is because they are reluctant to look for it. They generally rely on the moves of other traders.
This leads them to make decisions without any credible basis. Another typical characteristic of such traders is that they have poor timing, largely due to acting without due diligence. They have the ‘follow the crowd mentality’ whereby they conform to popular trends. Such traders are the type that always react on the extreme with regard to bad or good news in the market.
Types of Market Noise
Market noises take various forms. Most noise traders act on information from:
Daily reviews and items of focus in the media: These noises represent the whole range of financial talks that are present in media and financial blogs. The perpetrators are mostly gossipers, ‘online financial analysts’ and generally all quacks present in the online space and media that purport to be financial experts.
The information that originates from such people is just aimed to be sensational and probably drive traffic to a certain blog, boost the sale of certain financial magazines/newspapers, or probably to boost viewership.
Minor upward and downward movements of market prices and volumes. Such movements are not actually as a result of market activity but are as a result of the activities of noise traders. Thus, you might actually see shifts in the market, but they are just because of the erratic actions of noise traders.
The above act as triggers for noise trading. Somehow, noise traders see it as an opportunity to make more money. They may interpret it as a confirmation of certain long-term trend or the commencement of a certain short term trend and thus join the bandwagon. They somehow have an air of confidence surrounding them when they make such decisions.
Market noises are at times manufactured. Some expert traders are known to manipulate the system to reflect daily fluctuations in the price of a stock. Thus, if you are a noise trader and you make a trade basing your decision on information that you have acquired on that specific day, you are surely doomed.
Even with the above perspectives, noise trading is inevitable in any market. The possible effects of trading the market noise include:
- Adding liquidity by boosting volumes of transactions
- Due to the many transactions, brokers get fuller pockets through the many fees that will be paid for their services. On the other hand, traders end up with many costs hence lowering their profits from the frequent erratic trading.
In conclusion, trading the market noise may not be a smart move. This is because it is based on misinformation. Moreover, the cost of noise trading is much more significant than the net benefits owing to the risks involved. Therefore, the smart move is to carry out due diligence before trading and ensuring you stick to fundamental analysis rather than noise to arrive at trade decisions.