“Noise trader” is a financial term introduced by Albert Kyle (1985) and Fischer Black (1986). It refers to a stock trader who lacks access to inside information and makes irrational investment decisions (De Long et al., 1990)
A noise trader is a stock trader that does not have any specific information of the security. If the efficient market hypothesis holds, noise traders add liquidity to a market while not distorting valuations.
Therefore, the term noise trader is used to describe an investor who makes decisions regarding buy and sell trades without the use of fundamental data. These traders generally have poor timing, follow trends, and over-react to good and bad news.
A noise trader is somebody who practices noise trading, exclusively, continuously, and indiscriminately. Noise traders usually imitate other traders and follow the trends. When they see a price rise or fall, they jump aboard. They might even give less importance to information that is more fundamental but the potential effects of which take more time and efforts to analyze.
In fact, a market without noise traders will tend to break down, because prices in such a market will become fully revealing. Informed traders will not enter a market without noises, because it is impossible to profit from trading in a completely efficient market. Informed traders need the existence of noise traders to “hide” their trades and by trading on their private information, informed traders make profits. Through trading, informed traders gradually release relevant information to the market prices and together with the noise traders, they help bring the market back to equilibrium.
Noise trading is compulsive or hyperactive buying and selling activity or overtrading in financial markets, which is performed in the absence of meaningful new information, except erratic minor price moves, trifling or misunderstood news or unverifiable rumors.
Those frantic trader moves:
- are not only driven by market noises, as a flow of irrelevant information that does not really change the asset's fundamentals,
- but are also themselves a main source of market noise that initiates more erratic price moves unrelated to those fundamentals.
Noise trader risk
Noise traders create market anomalies and risks for other investors who base their valuations on fundamental analysis. The risk is that, although market prices differ from their "fundamental" valuations, the difference can get amplified instead of corrected.
The reason is that noise traders trust other traders' moves more than the fundamentals. Therefore they mimic those other players even when they are erring. They put themselves also in a risky position, as those other traders, also hyperactive, can change erratically their mood and behavior.
Different types of market noises
The rather meaningless market information, but which market traders are addicted to interpreting as decisive, usually takes the form of:
- Some minor "exogenous" information (anecdotal news, wrongly seen as changing the economic fundamentals),
- The "daily chatter" of financial media, bloggers, tip givers / sellers, and gossipers.
- Or most often minor vibrations / zigzags in market prices and volumes. They are random blips due mostly to noise traders who act erratically, upon whims more than rationality or upon relevant information.
Noise traders interpret those noises, even if produced by other noise traders,
- Sometimes as mispricing that offer arbitrage opportunities, in the hope that the price will swing back.
- More often as signals of either the birth of a short price trend or a confirmation of a long price trend.
- As opportunity to make money by following the scent.
- In terms of "representativeness heuristic” - seeing technical analysis configurations everywhere, as signs in the sky.
Noise traders spend time doing intra-day, or at least short term, buying and selling. This "overtrading" has several effects: -
- Its usefulness is to add liquidity to markets by boosting the transaction volume.
- In practice, it creates a quasi-continuous presence of counterparts for buy and sell orders.
- It brings a non-negligible source of fees for brokers.
- On the other hand, it is also a far from negligible source of costs for traders. This plays against the profitability of their trades and also, often, their survival as market players.
- It tends to bring market excesses into one area of the market or other - depending on the type of market information presented at the time - e.g. Rumor of war in oil-bearing countries will affect stock prices and volumes of oil companies on the stock market.
- Stock markets, and other financial markets, mostly when they are experiencing a bubble, have numerous noise traders that take the trend itself as a signal. Here noise trading and trend following go hand-in-hand.
Most noise traders believe they are making sound investment decisions when they follow market noise. Since the trades noise traders make are often not based on any fundamental data, they usually try to jump on the bandwagon and react quickly when they think noise is taking the market in a particular direction, and subsequently, they may make poor decisions by overreacting to good and bad news.
Since the noise traders are always watching the price movements of equities and listening to other aspects of noise in the market, their trades can often have a short-term effect on the market. This is because the constant buying and selling done by these traders causes an increase in price volatility. As the time horizon of an investment increases, however, the effect of noise trading becomes less and less noticeable.
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