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

    3 Charts That Suggest Now Is The Time To Invest In Real Estate (VNQ, SPG,PSA)

    Real estate assets have some of the strongest uptrends around. We'll take a look at three candidates poised for a move higher.
  2. Chart Advisor

    Stocks With More Upside Due to Bear Traps (TAP, SPY)

    A bear trap is a pattern that typically leads to at least a short-term rise in prices. Here are stocks exhibiting the pattern.
  3. Stock Analysis

    3 Risks U.S. Equities Face in 2016

    Find out why the probability of a U.S. stock bear market is increasing in 2016 and what the greatest risks are to the bull market that is almost 7 years old.
  4. Active Trading Fundamentals

    New Traders: Trade the Market in 5 Steps

    New traders shouldn’t throw money at securities without knowing why prices move. Follow these five steps to tilt the odds in your favor.
  5. Chart Advisor

    Watch For a Bounce in These Emerging Markets (BRF, PEK)

    While downtrends are clearly in control of the direction of many emerging market ETFs, short-term indicators suggest a bounce higher could be in the cards.
  6. Investing Basics

    Valuation Models: Apple’s Stock Analysis With CAPM

    The capital asset pricing model, or the CAPM, estimates the expected return of an asset based on the systematic risk of the asset’s return.
  7. Stock Analysis

    Will "FANG" Stocks Outperform in 2016?

    Facebook held the most bullish accumulation-distribution pattern into year’s end, telling investors to focus on this issue in 2016.
  8. Chart Advisor

    Stocks At Buy Points In Healthy Uptrends

    These stocks are in healthy long-term uptrends, and a recent pullback presents a buying opportunity.
  9. Chart Advisor

    The Uptrend Is Reversing In Financials

    Active traders are turning to financials because the close below several key long-term support levels suggest that the uptrend is about to reverse,
  10. Investing Basics

    What is an Indicator?

    Investors use indicators to measure economic conditions and forecast financial and economic trends.
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. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  4. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
  5. 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 >>
  6. 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 >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center