Forex Noise Trader Risk in Examples

The phrase “noise trader” refers to an investor or trader who makes buy and sell trade choices in the market without consulting with a professional or doing in-depth fundamental or technical research.

Day traders and retail investors are the most common sources of noise in the market. Because some of them don’t understand the underlying fundamentals, professional investors view them as amateurs. Many articles on “noise traders” characterize them as investors who make their own judgments without the help of a broker or financial analyst.

Noise traders tend to pursue trends, which is why they are often referred to as trend chasers.  They’ll get into a rising asset and easily dump one that’s going down.

As a result, they have earned the reputation of being traders who react too quickly, basing their judgments on the most recent ticker series without considering the underlying asset’s true fundamentals.

How does it affect trading?

Noise trading relies heavily on volatility. The more volatile an asset is, the more likely it is to attract speculators. People will flock to the forex market if it has risen sharply, looking for a fast profit. It is also quite common for short-term traders to try to avoid losses by selling an asset a short while after the price drops.

When this happens, its value could be adversely affected. Noise traders will rush to buy the currency pair that has just gained some short-term value, resulting in an increase in the price. As soon as investors begin to sell, a reversal will take place.

With regards to self-directed trading, for example, there was a significant increase in the amount of “noise” in the market around 2007. To put it another way, it was when the housing market was at its lowest point before it plummeted dramatically in 2008.

Over the last two decades, notable stocks have gone from boom to bust. The “dot com bust” is one example of a tech bubble. During the months leading up to the “dot com crash,” smart investors were forced to choose between following the buzz and losing money as a result of the influence of noise traders.

Asset managers were aware of the bubble in tech companies but also realized that if they ignored these stocks and underperformed, they risked losing their jobs.

When you look at how many “boom and bust” stories there have been in the last two decades, it’s clear that noise traders have a huge influence on the financial markets as well as the wider economy. Economic instability and bubbles result when well-informed investors give up on making markets more efficient.

The real-life examples above show us that professional traders may look at noise traders as amateurs but often fall victim to their trading practices. In addition, it also goes to show that the actions of noise traders permeate beyond financial markets and can affect national economies and even spill over to the global stage, as seen in the 2008 crisis. 

The solution to the “noise” in the market is to be patient enough to see your data-backed analysis overcome your gut or instincts led by fear or greed. 

As trading becomes more accessible to millions of people through mobile trading apps such as Robinhood, we are likely to see repeated episodes of noise trading having greater impacts on financial markets and the global economy as a whole. 

Example scenario

Let’s assume that an experienced and well-informed trader has analyzed the fundamentals of the USDJPY pair and conducted a thorough technical analysis. Following the analysis, he concludes that based on the performance of the US economy versus the Japanese economy, the fair exchange rate should be 114.40. However, in the meantime, some bad news about the US economy creates a negative sentiment around the dollar, and noise traders start selling it. Consequently, the USDJPY rate depreciates to 112.30.

In his own assessment, the smart trader feels that the market has “overreacted” to the news and that the exchange rate should be not less than 112.50. However, because of their sheer numbers, noise traders have their way, thereby proving the adverse impact they can have in a market.

Nonetheless, the smart trader can still hold on, knowing that the USD’s depreciation is only for the short term and that it will return to winning ways. Noise traders can also unduly inflate the value of an asset by buying it in large volumes based on a rumor or market news as opposed to the asset’s core fundamentals. 

Leveraging noise trader risk

Smart and patient investors can benefit from noise trader risk. Investors with short-term and emotional biases are in danger because they tend to over-buy or over-sell assets. Because of their biases, they end up pushing it beyond where it should be.

It’s possible, though, that prices will fall back to normal levels after a short while. In the long run, oversold instruments will recover their value. Overbought assets will likewise ultimately fall back to steadier price levels.

This is an opportunity for you as an investor. You can trade on price volatility if you think it has been driven up by “noisy” traders. It provides a chance to acquire the asset at a discount to their true worth. It also allows you to sell assets that have been overvalued and are unlikely to remain so in the future.

How to avoid falling for market noise

It may be an exaggeration to claim that you can escape all market noise. That being said, more experienced traders with a well-developed system always have a more strategic approach to their financial planning.

Thorough market research is the most effective strategy. Create standards and practices that you can’t stray from at random, depending on the research you’ve conducted. Trade with a clear understanding of your risk tolerance and avoid trading based just on speculation. As a trader, you can’t eliminate all the noise, but you can reduce it and develop a personal code of behavior.

Keep in mind that you shouldn’t always believe everything you hear or read. In order to avoid impulsive trading, it is important to conduct your own study.

In summary

Because of the uncertainty surrounding the opinions of noise traders, reasonable arbitrageurs are reluctant to place aggressive bets on the asset’s price against them. It is, as a result, possible for prices to deviate greatly from their fundamental values even when there is no fundamental risk present. Noise traders, in contrast, are able to earn a larger anticipated return than rational investors because they take on more risk themselves.