What Is Noise?

What Is Noise?

Let me explain what noise means in a broad analytical sense—it's information or activity that confuses or misrepresents the genuine underlying trends. In financial markets, you see this as small price corrections or fluctuations, which we call volatility, that distort the overall trend. This market noise makes it tough for you as an investor to figure out what's really driving the trend and whether it's actually changing or just going through some short-term volatility.

Understanding Noise

You should know that noise can come from stock market activity like program trading, dividend payments, or other events that don't reflect the overall market sentiment. Dividends, for instance, are those cash payments companies give to shareholders as a reward for owning their shares. The idea of noise was formally introduced in a key 1986 paper by economist Fischer Black, where he argued that we need to distinguish 'noise' from 'information' and pointed out that a lot of trading happens based on noise rather than solid evidence.

All trading has some speculation involved, but noise traders are especially reactionary—they rely on trending news, apparent price surges or drops, or even word of mouth, instead of doing fundamental analysis on companies.

Noise and Time Frames

Typically, the shorter your time frame, the harder it is for you to separate meaningful market movements from the noise. A security's price can swing wildly throughout a day, but most of that doesn't represent a real change in its perceived value. Day traders focus on these short-term movements, aiming to enter and exit positions in minutes or hours. Some noise traders try to capitalize on this market noise by buying and selling without any fundamental data.

If you look at a longer time frame, you get a clearer picture of the trend. For example, a stock might react wildly to earnings news for a few hours, but when you compare that to the trend over the past few months, the move might seem minor. Only hindsight tells you if the information was credible and if recent news or events will truly affect the trend. When you're buying and selling stocks quickly in the short term, it's hard to tell 'information' from 'noise'.

Causes of Noise

There are certain market fluctuations that are usually just noise. Intraday information often causes short-term price swings, but unless it's a major announcement or event, the overall trend stays intact once the noise dies down.

Short-term volatility or price moves can result from program trading, where large institutions have computers set to trade at specific price levels. You should also watch out for artificial bubbles, which happen when noise traders pile into a single company or industry. Market noise can even lead to corrections or reversals of more than ten percent in a security's value—these are often adjustments to significant overvaluations in a security or index.

Having a System: The Alternative to Noise Trading

Many traders, including myself when I think about it, create processes and rules to guide trading decisions and avoid noise. You establish preset risk and reward parameters, so you know exactly how much you're willing to risk on a trade and when to take profits or exit the position.

With a trading plan, you can determine with some precision what would make a profitable move in your current position. Investors without such a process are more prone to noise trading. Of course, even with a personal strategy, you're not immune to misinformation, but if you know what you're looking for, you're far less likely to be swayed by noise than those who just react to news or fluctuations.