Noise Trader

Updated on March 27, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Noise Trader?

A noise trader is a person who trades based on gossip or rumors rather than fundamental or technical analysis of the stock. Therefore, these irrational traders make bets based on insufficient and erroneous data. Without them, the market would be descriptive and effective.

Key Takeaways

  • A noise trader is an individual who trades based on gossip or rumors rather than conducting fundamental or technical stock analysis. 
  • These irrational traders make speculative trades based on insufficient and inaccurate information, which can introduce noise and irrationality into the market. 
  • While their actions may not be grounded in sound analysis, the presence of noise traders is essential for the functioning of financial markets. 
  • The presence of noise traders can impact the profitability of other investors. Their irrational behavior can lead to price distortions and inefficiencies in the market, potentially causing gains or losses for other participants. 

Examples

  1. James graduated in science and did not have sufficient knowledge and experience in the financial market. Therefore, he bought some shares of Berkshire Hathaway for $3,00,000.00 on 15th April 2020. Today, James received the news that Berkshire Hathaway must pay the penalty to the government for non-compliance with the corporate act. As a result, he thought its share price would fall due to negative information about the company, and he booked the share price for $3,10,000.00, creating market volatility.
  2. Apple has earned a huge net profit; Mr. Martin is a noise trader and bought the shares of Apple, pushing its stock price higher. After one hour of trading, share price growth declines, and the stock is closed at a lower cost than the open price. It reflects the stock’s volatility.
  3. Paul has 5,000 shares of Walmart. They currently trade at $100 per share. If noise traders overreact to the bad news related to the company or country and assume the price dropped to $80 per share without any technical or fundamental justifications. It will cost the investors $1,00,000.00.
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Video Explanation of Noise Trader

 

Identifying Noise Trader

Impact

  • It impacts the market significantly because they trade based on rumor news.
  • It can increase or decrease the share price, which is not the actual value.
  • They cause volatility in stock demand due to increased trading.
  • These traders take excessive risk and higher consumption of stock, which significantly changes the stock price.

Noise Trader Risk

  • If a noise investor decides without having sufficient knowledge and experience, then there might be some chances that noise investors can book the loss on trading.
  • It can affect the price adversely, even when no certainty seems fundamental and technical.
  • The risk of loss on an investment/trading arises from such traders.

Conclusion

The presence of noise traders is critical for the feasibility of financial market-making. It can increase or decrease the profit or loss of other investors. It increases the volatility of the stock market. Decisions taken by such traders can be correct.

Frequently Asked Questions (FAQs)

1. What is the difference between a noise trader and a sentiment trader?

A noise trader is an investor who trades based on random or irrational factors rather than fundamental analysis or market information. Instead, they make decisions based on emotions, rumors, or short-term market trends, often leading to inefficient pricing and increased volatility. On the other hand, a sentiment trader is an investor who considers market sentiment and investor psychology when making trading decisions. 

2. What is the difference between a noise trader and a market timer?

A noise trader is an investor who makes trades based on random or irrational factors, such as noise or short-term market trends, without considering the underlying fundamentals of the assets. On the other hand, a market timer is an investor who attempts to predict the overall direction of the market or specific asset prices based on various indicators, including technical analysis, economic data, or market trends. 

3. Are there any strategies or mechanisms in place to mitigate the impact of noise traders on market outcomes?

Yes, there are strategies and mechanisms to mitigate noise traders’ impact on market outcomes. For example, market regulations, such as circuit breakers and trading halts, are implemented to pause or limit trading activities during periods of high volatility or extreme market conditions. These mechanisms help prevent panic selling or irrational trading decisions from noise traders. 

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