Noise trader is generally a term used to describe investors who make decisions regarding buy and sell trades without the support of professional advice or advanced fundamental analysis. Trading by noise traders tends to be impulsive and based on irrational exuberance, fear or greed. These investors typically follow trends and overreact to good and bad news.
Noise traders are substantial contributors to high volume trading days. This category of traders encompasses non-professional investors and may also include technical analysts. Generally noise traders can overinflate the price of securities in bullish trading periods and depress the price of securities in bearish trading. For mainstream investors, these affects can be known as noise trader risks.
Technical Analysts
Technical analysts may be considered noise traders since their trading strategies are usually unrelated to company fundamentals. These traders can form a substantial portion of the market’s trading volume. Active technical analysts and full-time day traders make trades throughout the trading day based on price action indicators and patterns that are derived from daily price series charts. Since they contribute to a high volume of daily trades, their orders can substantially affect a stock’s price either positively or negatively. In some situations their trades may follow professional investor sentiment while in many cases they will not which can adversely affect pricing for other market participants.
Volume Indicators
To combat some of the irrational and egregious security price effects from noise traders, investors may choose to regularly follow the movement of the Positive Volume Index (PVI) and the Negative Volume Index (NVI). These indexes were first developed in the 1930s and became popular in the 1970s.
The Positive and Negative Volume Indexes can help an investor to discern whether price movements in the market are based heavily on volume. Both the Positive and Negative Volume Indexes are calculated with price movement variables that depend on the day to day change in volume.
Positive Volume Index:
If current volume is greater than the previous day’s volume, PVI = Previous PVI + {[(Today’s Closing Price-Yesterday’s Closing Price)/Yesterday’s Closing Price)] x Previous PVI}. If current volume is lower than the previous day’s volume, PVI is unchanged.
Negative Volume Index:
If current volume is less than the previous day’s volume, NVI = Previous NVI + {[(Today’s Closing Price-Yesterday’s Closing Price)/Yesterday’s Closing Price)] x Previous NVI}. If current volume is higher than the previous day’s volume, NVI is unchanged.
Many investors believe that the Negative Volume Index is the best indicator of price trends since it generally tends to rely on price affects caused by professional and institutional investors. Adversely, the Positive Volume Index can also be a helpful indicator for discerning whether prices are being heavily influenced by noise traders since they are often more of a factor during high volume trading periods.
A form of market risk associated with the investment decisions of noise traders. The higher the volatility in market price for a particular security, the greater the associated noise trader risk
Behavioral finance researchers have attempted to isolate this risk in order to explain and capitalize upon the sentiment of the majority of investors. Noise trader risk is assumed to be more readily found in small-cap stocks, but has also been identified mid- and large-caps.
For example, if the noise trader risk for a particular stock is high, an issuance of good news related to a particular company may influence more noise traders to buy the stock, artificially inflating its market value.
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