Noise Trading

Noise trading refers to the stock market trading session where traders buy or sell without referring to the company fundamentals. It is a way of reacting to the noise created in the market. Hence, traders implement this trading to book short-term profits from market fluctuations.

The noise trading theory is a vital element of behavioral finance that focuses on the trader's behavior towards the market. Thus, traders who have no company knowledge or insider information trade on the current news trending in the market. Hence, they are known as noise traders. 

Noise trading theory refers to the trading conducted based on the noise circulating within the market. It needs a proper ground for trading. Hence, traders assume that the noise created is based on valid information. Therefore, the trades done at this time might be irrational and may hold little value in the long term. So, if a particular stock has hit the green candles (or turned bullish), the noise traders may buy the stock even without confirming with the company fundamentals or actual information. Hence, the majority of the noise traders are among individual investors. 

The early origin of noise trading and stock market volatility dates to the late 1900s. In 1985, Albert S. Kyle gave the Kyle theory pertaining to the noise created in the market. Here, noise trading and liquidity go hand in hand. This theory connects insider trading with the liquidity of the noise traders. It states investors following noise (or random trading) make ineffective decisions compared to the insiders, who make bold and aggressive moves. Later, in 1986, economist Fisher Black added similar views to this. Black suggested that investors who had no insider information act irrationally based on the noise and take that noise as an edge for their trading.

Similarly, even the efficient market hypothesis (EMH) has explained the existence of noise trading and stock market volatility. It explains how this trading lasts for the short term, reacting to market fluctuations. However, in the long term, the noise traders turn rational. In a contradictory situation, with noise, the traders' market is complete. There would be minimal trading in individual assets. 

Let us look at some real and hypothetical examples of this trading to comprehend the concept in a better way:

Example #1

Suppose James is an investor who has recently started trading in the stock markets. He has started gaining sound knowledge of the market and how the trading occurs. However, James was more into technical analysis rather than fundamental analysis. In short, he used to trade randomly based on the current information he had on that stock. So, if a company had declared positive news, he used to buy it and trade later. But there was a downside to it in the later stages. 

A month later, HAPPY Ltd. stock rose by 10%, and it tempted James to indulge in noise trading. In short, he brought the stock at the trending price without even analyzing the company fundamentals. As a result, in the later stages, the stock fell badly to 20%, and James faced a huge loss. 

Example #2

According to a recent news update as of October 2023, the crypto experts share their opinions on Bitcoin. The report suggested how the noise created in the market has uplifted the crypto coin to another level. As a result, in the following weeks, the coin went into a market rally to a level of $51,751.20 despite the allegations imposed by the Securities and Exchange Commission (SEC). 

Various consequences affect the investment decisions taken by investors and traders. Following are the factors that are affected by this trading. Let us look at them:

• Affects The Informational Efficiency Of The Stock: This type of trading always has a consequent effect on the stocks and indices trading in the market. Informational efficiency depicts how a particular stock is able to absorb information from the market. Such markets are able to give accurate prices back to the investors. However, any presence of such trading can lead to price efficiency. It mainly affects large liquid stocks.
• Hinders The Market Stability: There is a similar effect visible on the market due to noise trading and asset pricing factors. It hinders the stability (or equilibrium) of the assets. So, if there is random trading in the market, the price follows an uptrend. However, in the later stages, bubbles form that can convert profits into losses. 
• Increases Volatility: Similarly, this trading also increases the volatility of the assets. As noise traders trade randomly, the assets become more sensitive to market segments. It later causes huge fluctuations in the stock prices, leading to volatility. In short, there is a direct relation between noise trading and asset pricing factors.