Noise removal is one of the most important aspects of active trading. By employing noise-removal techniques, traders can avoid false signals and get a clearer picture of an overall trend. Here we take a look at different techniques for removing market noise and show you how they can be implemented to help you profit.

What Is Market Noise?
Market noise is simply all of the price data that distorts the picture of the underlying trend. This includes mostly small corrections and intraday volatility. To fully understand this concept, let's take a look at two charts - one with noise and one with noise removed:

Before noise is removed:

AT_RemoveNoise_1r.jpg

Figure 1

After noise is removed:

AT_RemoveNoise_2r.jpg

Figure 2

Notice that in Figure 2, there are no longer any areas in which the trend is not easily seen, whereas in Figure 1, it is often difficult to identify whether the trend is changing on some days. The technique used in this chart is averaging - that is, where the current candle factors in the average of prior candles in order to create a smoother trend. This is the aim of noise reduction: to clarify trend direction and strength. (For more insight, check out Short-, Intermediate- And Long-Term Trends.)

Let's take a look at how we can determine these two factors and combine them to create reliable charts that are easier to read.

Isolating Trend Direction
Isolating trend direction is best done through the use of specialized charts designed to eliminate minor corrections and deviations and only show larger trends. Some of the charts (such as Figure 2 above) simply average prices to create a smoother chart, while others completely recreate the chart by taking only trend-affecting moves into consideration.

Renko Charts
One example of a chart type that only uses trend-affecting moves is the Renko chart, named after the Japanese term "renga", meaning "brick". Renko charts isolate trends by taking price into account but ignoring time.

They are created by using a simple three-step process:

  1. Choose a brick size. This is simply the minimum price change required for a new brick to appear.
  2. Compare the current day's close with the high and low of the previous brick.
  3. If the closing price is higher or lower than the top of the previous brick by at least the size of one brick, one or more bricks are drawn in the next column in the respective direction.

Let's take a look at an example:

AT_RemoveNoise_3r.gif

Figure 3

As you can see, it is much easier to identify trends on these charts than on traditional candlestick charts. Further noise reduction can be obtained by increasing the size of the bricks; however, this will also increase the intra-trend volatility - make sure that you have enough capital to withstand this volatility.

Overall, Renko charts provide an excellent way to isolate trends, but they are limited by the fact that they don't provide a way to determine trend strength other than simply looking at the trend length, which can be misleading. We'll take a look at how to determine trend strength later in the article.

Heikin-Ashi Charts
A second type of chart that can be used for noise reduction is the Heikin-Ashi chart. These charts use a strategy similar to the charts seen in Figs. 1 and 2: they factor in the current bar with an average of past bars in order to create a smoother trend. This process creates much smoother price patterns that are much easier to read. (For more information and examples, see Heikin-Ashi: A Better Candlestick.)

These are the charts most commonly used when reducing market noise; they can easily be used with other indicators because they don't factor out time. Another added benefit is that they also smooth out the indicator because the price bars are used as indicator inputs. This can help make indicators far easier to read.

Kagi Charts
Kagi charts are designed to show supply and demand through the use of thin and thick lines. New lines are created whenever a new high or low is established. By isolating highs and lows, it becomes much easier to see the larger trends.

Let's look at an example:

AT_RemoveNoise_4r.gif

Figure 4

Trending times are then defined as times when demand exceeds supply (uptrend) or supply exceeds demand (downtrend). Finding trends becomes as easy as looking for thick or thin lines.

These charts are also excellent for noise reduction, but they are limited because they can't determine trend strength other than by measuring the move lengths, which can be misleading.

Determining Trend Strength
Trend strength is best gauged through the use of indicators. For the purposes of this article, we will take the most popular indicator - directional movement index (DMI) - and its derivative, the average directional movement index (ADX).

The DMI indicator is the most widely used trend strength indicator. This indicator is divided into two parts: +DI and -DI. These two indicators are then plotted to determine overall trend strength.

The ADX indicator is simply the averaging of the two DMI (directional movement index) indicators (+/-) to create a single line that can be used to instantly determine whether a price is trending or dormant. (For more on this, read Directional Movement - DMI.)

Let's see an example of how this can be useful:

AT_RemoveNoise_5r.jpg

Figure 5

As you can see, the slope increases at a greater rate when the trend is stronger and at a lesser rate when the trend is weaker. Typically, the ADX is set at a 14-bar range, with 20 and 40 being the two key points. If the ADX is rising above 20, it signifies the beginning of a new trend. If it rises above 40, that means the trend is likely about to end. As you can see from Figure 5, it can give you a fairly accurate read.

Creating a Usable Strategy
Although the ADX appears to work well on its own, market volatility can cause second-guessing and false signals. However, when combined with chart types that more easily highlight trends, it becomes a lot easier to identify profitable opportunities.

Using a combined analysis is as simple as determining whether the chart pattern's sentiment is the same as the indicator's sentiment. Therefore, if you are using Heikin-Ashi and ADX, simply check to see what the trend direction is on the chart and then take a look at the trend strength shown on the ADX. If both are telling you that there is a strong trend, then it may be a good idea to enter.

Here's an example:

AT_RemoveNoise_6r.jpg

Figure 6

Here we can see the trends are smoothed out by the use of averaging techniques (like Heikin-Ashi) and are being confirmed through the use of indicators (like ADX). This gives us a clear and reliable picture of the current market situation, without any unnecessary clutter (market noise).

Conclusion
As you can see, chart analysis is much easier when using noise-removal techniques. They can help you avoid costly false signals and other mistakes, while allowing you to quickly and accurately locate and capitalize on trends.

Related Articles
  1. Chart Advisor

    Gold Struggles to Climb Higher and May Fall Soon

    Traders will be watching the price of gold over the coming weeks. We'll take a look at how a couple major moving averages are suggesting that the next move could be lower.
  2. Technical Indicators

    Use Market Volume Data to Determine a Bottom

    Market bottoms often carve out classic volume patterns that let observant traders make fast and accurate calls.
  3. Mutual Funds & ETFs

    ETF Analysis: First Trust Dorsey Wright Focus 5

    Take a closer look at the First Trust Dorsey Wright Focus 5 ETF, a unique and innovative fund of funds based on momentum and relative strength.
  4. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  5. Technical Indicators

    4 Ways to Find a Penny Stock Worth Millions

    Thinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
  6. Trading Strategies

    Who Actually Trades or Invests In Penny Stocks?

    Although penny stocks are highly speculative, millions of people trade them daily. Here are 10 different types who do.
  7. Chart Advisor

    4 Stocks Still Flashing Buy Signals

    In the midst of volatility and a big market sell-off last week, these stocks are flashing buy signals.
  8. Technical Indicators

    Understanding Trend Analysis

    Trend analysis is the use of past performance to predict future price movement of a security.
  9. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  10. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
RELATED TERMS
  1. Fintech

    Fintech is a portmanteau of financial technology that describes ...
  2. Indicator

    Indicators are statistics used to measure current conditions ...
  3. Intraday Momentum Index (IMI)

    A technical indicator that combines aspects of candlestick analysis ...
  4. Mass Index

    A form of technical analysis that looks at the range between ...
  5. Money Flow Index - MFI

    A momentum indicator that uses a stock’s price and volume to ...
  6. On-Balance Volume (OBV)

    A momentum indicator that uses volume flow to predict changes ...
RELATED FAQS
  1. How are True Strength Index (TSI) patterns interpreted by analysts and traders?

    The true strength index (TSI) is a multifaceted technical indicator that can track trends and produce trading signals. Its ... Read Full Answer >>
  2. How do experienced traders identify false signals in the market?

    Experienced traders often use multiple technical indicators and theories for market analysis to develop trading strategies. ... Read Full Answer >>
  3. Tame Panic Selling with the Exhausted Selling Model

    The exhausted selling model is a pricing strategy used to identify and trade based off of the price floor of a security. ... Read Full Answer >>
  4. Point and Figure Charting Using Count Analysis

    Count analysis is a means of interpreting point and figure charts to measure vertical price movements. Technical analysts ... Read Full Answer >>
  5. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  6. How are double exponential moving averages applied in technical analysis?

    Double exponential moving averages (DEMAS) are commonly used in technical analysis like any other moving average indicator ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!