Noise Traders Find Profit in Chaos
Noise traders aren’t the most scientific of traders. Instead, they tend to go on gut feeling and value non-traditional metrics. These traders seek to capitalize on market volatility. They open positions just before they believe a breakout will occur. In fact, they can come from technical or fundamental backgrounds. What distinguishes them is their deviation from traditional metrics in either case.
It’s often thought that retail traders constitute most of the “noise” in an active trading day. That said, institutional investors often find themselves making trades on impulse or gut feeling. As a result, significant volume (noise) on a given trading day could be attributed to irrational decision-making. In many cases, noise trading is a catalyst behind price momentum, up or down.
Not Just “Idiot Traders”
Noise traders have the unfortunate moniker of “idiot traders” in conventional circles. The nickname comes from their unconventional trading style. These traders often ignore quantifiable metrics like P/E, P/B, EBITDA or other financial factors. They’re also unconcerned with qualifiable metrics like a company’s moat or leadership. Instead, they’re focused on how they think the market will react to the current price of the stock.
The real definition of noise traders tends to be a bit ambiguous. In some cases, it’s aimed at new retail investors who trade on impulse. In other cases, it’s retail investors who use unconventional metrics. Somee people believe these traders are synonymous with pure pattern traders. Context matters in defining noise traders. Nevertheless, the result of their trading style is “noise” in the form of price fluctuations and volume swings.
Noise Traders vs. Technical Traders
There’s often a lot of confusion between noise traders and technical traders. Some fundamental traders choose to lump them together, but there are key differences.
For starters, while noise traders may use technical patterns to justify their trades, they often lack the analysis behind it. Proficient technical traders can tell you why a pattern is forming and what it represents. They simply see the pattern. They also observe patterns in narrow context, frequently justifying their gut instead of deciphering the pattern.
Noise traders also have an incomplete process. Technical traders choose stocks based on their market performance (good or bad) and potential for trend capitalization. Noise traders gravitate toward stocks with positive market sentiment. In this way, noise traders often consider themselves momentum traders, but again, without the technical analysis skills behind their decision-making.
The problem with noise trading is that it tends to drag down technical trading. Fundamental traders who are already suspect of technical analysis see noise trading as confirmation of market oversimplification. The reality is, these traders are more impulsive than technical traders.
Noise Traders Use Unconventional Wisdom
“Unconventional wisdom” is commonly a euphemism for total disregard of conventional security analysis. Noise traders tend to speculate and when they do use analysis, it’s usually to justify a thesis, not assess it.
Noise traders tend to create their own benchmarks for stock performance outside of conventional means. These metrics have almost no bearing in reality and are frequently no better than a coin flip. The problem is, they tend to attribute successes to their “system” and losses to market factors.
Enough noise surrounding a stock can cause major discrepancies in the way it trades. There’s no better example of this than the recent GameStop (GME) fiasco, fueled by noise traders. The share price went from ~$17 in January 2021 to nearly $350 by the end of the month. Driven by reports of over-shorting, retail investors drove up the price to all-time highs. The security’s Book Value of Equity Per Share (BVPS) in 2021 is just over $5, for context.
The Pitfalls of Being a Noise Trader
There are numerous pitfalls to being a noise trader. The biggest problem is that using unconventional metrics lowers the benchmark for success. How can you know if your system is valid without a large sample size? Many traders are content to keep using a strategy so long as it works, but are quick to abandon it when it doesn’t.
Noise traders also have trouble justifying their actions in the context of a traditional trading framework. They often rely on emotional reasoning, which can’t be quantified or qualified in their action to enter or exit a position. “I think this stock is undervalued” is a much different sentiment from showing technical or fundamental analysis to prove this sentiment.
Finally, they tend to get taken advantage of by more conventional investors. Using the GameStop debacle, many institutions with long positions sold on the influx of noise trading. Since institutional investors harbor more trading power, they reaped significant profits and left others fighting to maintain the share price on sentiment alone.
The Bottom Line on Noise Trading
It’s important to do your research if you want to invest in the stock market. Therefore, sign up for the Profit Trends e-letter below. This daily newsletter provides stock tips and up-to-date market trends.
It’s not advisable to consider yourself a noise trader. If you find yourself making impulsive or irrational decisions, step back to consider them. The good news is that with practice and attention, noise traders often become more technical. Pattern recognition is often followed by informed technical analysis. Sentiment about a company can evolve into fundamental assessment. New traders who are serious about trading rarely remain noise traders for long.