Noise trading

According to Black, in his basic model of financial markets, noise is the opposite of information. People often trade based on information in a conventional way. They have correct expectations about the profits and returns from these trades. However, sometimes people trade based on noise, as if it were information. If they expect to profit from so-called "noise trading," they are mistaken. Yet, the truth remains that noise and noise trading are present in all liquid markets. Noise creates opportunities for trading in financial markets, but it also makes them imperfect. Without noise trading, there would be very little trading in individual assets. People would hold individual assets, either directly or indirectly, but would not trade them. Traders looking to mitigate exposure to foreign market risk would trade through investment funds, portfolios, index futures, or index options. They would have very few reasons to trade shares and stakes in individual companies.

Black's explanation is as follows: A person with information or insight into an individual firm will want to trade but will realize that on the other side of the trade will be another person, also with some information or insights about the firm. From this perspective, is it even advantageous for one of the parties involved in trading to proceed? If someone who knew the positions of both traders and the background of the trade were to look at the situation, they could determine which party is making a mistake. If the party making the mistake realizes their error or decides not to trade for some reason, then trading based purely on information will not occur. Noise trading, therefore, represents the crucial missing ingredient in trading. Noise trading is trading in the presence of noise as if we had information. People trading in noise or based on noise are willing to trade even when, by objective assessment, they should not. This occurs mainly because these traders believe that the noise affecting them is information, or they simply enjoy trading.

Market liquidity increases with more noise trading because it allows us to observe prices. Ultimately, however, noise trading also introduces noise into the prices themselves. Stock prices respond not only to the information used by "information traders" but also to the noise involved in "noise trading." When the amount of noise trading rises, it makes trading more advantageous for information traders, but only due to the greater noise present in prices. An increase in information-based trading does not automatically mean that prices are efficient or optimal. This is explained not only by the entry of new information traders into the market but also by the greater market share of existing information traders and their increased spending on acquiring information.

It follows that what is necessary for a liquid market also causes lower price efficiency. Noise creates opportunities to profit from trades while simultaneously making advantageous trading more challenging. In the next article, we will take a closer look at rumors, which experts consider a very specific and significant element present in the financial world, straddling the line between information and noise.

Sources:

1. BLACK, F. 1986. Noise. In Journal of Finance, č. 41 (3) 1986. ISSN 0022-1082, s. 529-543.

2. https://www.investopedia.com/terms/n/noisetrader.asp
   

3. https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/noise-trader/ 
   

4. https://www.sciencedirect.com/topics/economics-econometrics-and-finance/noise-trading


Images: Shutterstock - ID 242289160, 1710722323