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Noise Traders, A Brief Review
Introduction
Internet http//www.cisco-futures.com
Email dljones@cisco-futures.com
By Donald L. Jones, CISCO Futures
April 9, 2004
Financial economists identify two classes of traders, the
"informed" and "uninformed". Informed traders are presumed to understand
the market's
basics and arrive at value by standard principles (knowledge of interest
rates and dividends, insider information, etc.).
Uninformed traders, also
called "noise traders" by economists, use market activity for trading decisions.
What is an Informed Trader?
Informed trader is a euphemism for insider. It is one who has some
specialized information to act on. In equities, the inside information
may be specific (company ABC is near bankruptcy) or the insider may be
particularly good at understanding company filings. In futures, the
insider may know of pending large contracts for grain, etc. Usually an
informed trader is a professional working for a Wall Street type firm.
Informed traders tend to trade heavily on their information, which is
often, but not always, correct. Informed traders often are identified
as the "rational investor" so beloved by economists. Incidentally, most
brokers are not insiders, although the uninformed trader is often led
to believe that they are. Some firms even forbid their brokers to trade
at all.
What Is an Uninformed (Noise) Trader?
In the references below, noise traders are variously described as:
1) Individuals who trade on what they think is information but in fact is
merely noise, such as "market indicators". They buy and sell on grounds
that are unrelated to the larger movements of the market, although they
believe the 'information' they have is relevant.
2) One who doesn't have any special information but trades for exogenous
reasons; e.g., to raise cash. These traders are active, making a market
for others; they provide someone to exchange with, i.e. they increase
market liquidity.
3) In periods of high volatility a large fraction of agents (traders) are in
the noise group (some normally informed traders become uninformed).
4) Small speculators rely on nonfundamental information, thus they are
noise traders.
5) Noise traders are more aggressive on average than informed traders and
necessarily, a new generation arrives each trading period.
A typical composite noise trader is 1) a small speculator, 2) who has no special
(fundamental/inside) information, 3) who's trading increases volatility and
4) may be a chartist, a technical analyst, a trend follower, etc. Further,
the odds are against noise traders because informed traders are often right
and the noise trader is on the other side of the transaction.
It is arguable that all traders are noise traders at times since there
is no demonstration that the correct fundamental value of a market can be
found, although truly insider information almost always works. Some nominally
"informed traders", like mutual funds that rotate their
portfolios regularly, typically do worse than the market index. So
they too, often seem to be noise traders. Research has shown that in
times of high volatility some normally informed traders slip into the
uninformed ranks.
Fate of the Uninformed Trader
Is the small speculator doomed? Many are because they stubbornly believe
they can predict the market. They are buoyed by their trading successes,
believing these derive from their knowledge or methodology. Losses to them
just means they have more work to do. In reality, a noise trader with a
fifty - fifty chance of winning on each trade can have a string of successes
strictly from the statistics. In the long run most uninformed traders lose,
and as noted in 5) above are replaced by new recruits. A small percentage
continue to survive because they have developed a good knowledge of the
market and follow good trading habits.
Hope for the Uninformed Trader
Can the small speculator become an informed trader? Surprisingly, yes.
The informed trader is one with a good grip on value. It follows that
any trader can become informed by finding the current market value of a
stock or commodity. Current value is rarely the long term value of the
fundamentalist; rather it is the value perceived by the current market.
Today's value defines the price region the bulk of the traders see as fair.
Value in the near term (day) is discovered by the Market Profile.
Market Profiles Background
Market Profile value is a condensed picture of market activity. It finds the
price region most traded, the winner of the day's price popularity
contest.
Longer term value, 5, 9, 13, 20, 30,... days comes from the Overlay Demand
Curve, a consolidation of Market Profiles.
Overlay Demand Curve Background
Market Profile tracks the day-by-day variation in value, while the
Overlay Demand Curve gives the longer term value ranges. These are the values
assigned by the market on the various time scales. Market Profile is
sensitive to demand and volatility, both of which may change substantially
from day to day. Overlays, looking at the bigger picture, are more stable.
Auctiom Market Data is a term we use to cover both Market Profiles and
Overlay Demand Curves. The utility of Auction Market data to a trader
lies in its ability to identify value. Trades are then made when value
changes.
In a recent
study on Pulses (change in demand coming into the market) in the Nasdaq
futures, a 20 day Overlay showed balance in 37 of the 40 weeks tested. The
5 day Overlay was in balance 28 of the weeks. Further, the 5 day Overlay
broke out the next day in 37 cases. The breakout pulse traveled at least
200 points in 29 of the cases (e.g. from 115500 to 115700).
These Auction Market data are as readily available to the uninformed
speculator as to the insider. They level the playing field for those
who understand how to use them. An article on trading models illustrates
the use of Auction Market data in the Trading Plan Case Study section.
Trading Model Development
For more detail on becoming an informed trader, see:
From Noise Trader to Insider
Addendum and References
Noise traders are well described by Black [1]:
Noise Traders: Individuals who trade on what they think is information
but in fact is merely noise. They buy and sell on grounds that are
unrelated to the movements of the market, although they believe the
'information' they have is relevant.
Economics Glossary [2] defines a noise trader as:
One who doesn't have any special information but trades for exogenous
reasons; e.g., to raise cash. These trades make a market for other
traders, someone to exchange with.
Sornette [3] adds: Noise traders: chartists, technical analysts...
Lux and Marchesi [4] say:
Factoring in the behavior of noise traders destabilizes the market.
Such activity typically leads to periods of extreme price volatility.
In periods of high volatility a large fraction of agents are in the
noise group.
Ivars Peterson [5] quotes Lux and Marchesi [4]:
"Their mathematical analyses demonstrate that, in the realm of the stock
market, information in does not necessarily lead to correspondingly
rational behavior out.
Peterson continues: In an efficient, rational market, the magnitude of
stock price changes would reflect the scale of the inputs that influence
the price. In other words, the movements of price are an immediate and
unbiased reflection of incoming news about future earnings prospects.
This often is not what actually happens.
Noise Trader Demand in Futures Markets, Sanders, Irwin and Leuthold, U.Ill
Urbana [6]
Conclusions:
Small speculators rely on nonfundamental information, thus
they are noise traders.
Noise trader demand is an increasing function of past returns.
Noise traders have relatively long memories, positive feedback.
Noise trader demand is very volatile, can impact markets.
The Friedman Conjecture [7]
If noise traders do not trade on fundamentals then
they consistently buy high and sell low.
Over time they will consistently lose wealth compared to the
informed and eventually have a negligible effect on prices.
unless
They are more aggressive on average than informed traders and
a new generation arrives each trading period.
References
[1] Fischer Black ,1986, Noise JFin v41 p529-543
[2] //economics.about.com/cs/economicsglossary/g/noise_trader.htm
[3] Didier Sornette, 2003, Why Stock Markets Crash, Princeton U. Press
[4] Lux and Marchesi, 1999, Nature 397, p493
[5] Ivars Peterson's Math Trek, www.maa.org/mathland/mathtrek_2_22_99.html
[6] OFOR Paper Number 96-02, June 1996 //econwpa.wustl.edu:8089
[7] www.behavioralfinance.net/noise/s...