Stock Market Noise

If you trade stocks online in a brokerage account, you probably know the frustration of intra day price movement for no apparent reasons. Remember, daily price and volume fluctuations in the market can easily confuse your technical chart analysis and ability to find out a clear interpretation of market direction. Stock market activities are usually caused by program trading, short term events such as company news and/or analyst downgrade or upgrade on a certain company. Collectively, all these daily fluctuations are known as "market noise" and can have a profound impact on your trading strategy.

In general, the shorter the time frame, the more difficult it is to separate the meaningful market movements from the noise. In the past, most individual investors used to focus on long term market outlook but due to increasing number on hedge funds and greedy Institutional investment firms, that strategy doesn't work anymore. For example, if you bought a stock during internet boom period(1998 -2000 timeframe) and never sold it because you were confident of its long term outlook, more than likely you lost money. Remember NASDAQ was over 5000 during those days and now eight years later we're still below 2500 and there isn't any chance of going back to 5000 any time soon. So buy and hold strategy isn't going to work anymore. While you can't time the market for lows and highs, you should always take profit when you feel that you have reached your investment goals with a certain stock.

Because of the current markets trends, you now have to focus on a short and mid term outlook and "market noise" has lot more significant impact on your investment strategy than it ever has. In today's markets, there are two types of investment decisions that you could make. You could either sit on the sideline and wait for market to find a clear direction before investing or you trade with focus on market noise and short term trend. It's your choice but you run the risk of waiting for long time if market is in transition or doesn't have a clear direction. For most people, it makes more sense to stay involved with the market and make money while for others it is not even a choice. For these people, they must invest and trade regardless of market conditions. Whatever is your long term goal as an individual investor, there is definitely some value in understanding market noise and adding it to your short term trading strategy.

So how do you make money with a trading strategy that uses " market noise"? To understand a trading strategy driven by market noise, you must first understand how to pick out market noise during chart analysis. One of the important elements of understanding market noise is Candlestick.

Japanese are credited for the invention of candlesticks. They first appeared around 1850 but became very common by 1900. Candlestick charting provides useful information when you're more interested in what happened rather than why it happened. All market fluctuations and underlying price movement is reflected in candlestick charting. There are opening and closing prices as well as daily highs and lows for the period. Remember, candlestick offers a great tool in technical analysis. While they have information on the session, they do not reflect the sequence of events between open and close. Highs and lows are clearly marked but you can't tell which came first. A stock could close exactly at the same priced it opened and could still have very high volatility. As you can see, candlesticks do provide lot of information on price movement, but they don't explicitly provide information on sequence of price movement. But the good news is that you don't need a lot of information on sessions to understand market noise. You can just read a candlestick chart and see the gap from open or close to relative highs or lows of the day to figure out how much impact "market noise" had on the session. For example, if you see a long candlestick with very small difference from high to open/close or low to open/close, you know that there wasn't much "market noise" for the period. If you see short candlestick with big difference between session highs/lows and open/close, you should expect to see a lot of "market noise". Now that you know how to identify market noise, how do you profit from it? Before we discuss the trading strategy, you must understand the reasons for the "market noise". If it is related to overall market conditions, your chances of making a profits are not as great as if market noise is limited to the stock of your interest.

To explain the trading strategy using market noise, let's look at a recent example. Below we have a six months chart of Corning(GLW). On a cursory look, you don't see anything out of ordinary. However, if you pay close attention, you'll notice that stock had a very high level of "market noise" during this period.

As you can see, stock started to experience a higher "market noise" right after it reported it's second quarter results in late July. that's usually is the case with most stocks. You'll notice a high level of "market noise" or volatility right after company results or significant news with long term consequences. If you take a closer look at the week of August 13-20th, you'll notice that stock had a intra day swing of almost 7%. This pattern continued with even wider swing(almost 11%) on Nov 8th. There were also numerous trading sessions with intra day swing of 5% o more. So what can we learn from it? People who focus on "market noise" and execute trades based on market noise are known as swing traders or market noise traders. There is obviously a lot higher risk with these trades as compared to regular buy and hold type trades but payoff is huge. Just look at the price movement from August 16th to September 12th(25%) or Nov 8th to December 11th(23.2%). This is on average 24% return within a 30-day window. These types of returns are rare in a stock or in a market that doesn't move much in either direction but market noise can get you those returns. Another important observation from the chart is that the overall price movement in the stock during those six months was insignificant. So if you would have just bought and held this position for six months, you would have lost money instead.

How you should trade a stock that has a market noise? Well, that's depends upon your risk tolerance. First thing you must do is to correctly identify stocks and trading opportunities that can benefit you due to market noise. Once you have done that, you should keep an eye for wild intra day swings. If you see a 8% to 10% or more drop on open, you should get long for the quick profit. On the other hand, if you see a quick 10% jump during a day, you should open a short position. One critical point to remember is that your success rate will be much higher if you go long on a day when stock falls 10% during intra day swings. The main reason - stocks fall is lot steeper than the rise. Also, going short is a risky strategy and should only be deployed by people who really understand the risk of shorting stocks.

On a final note, it is important to point out that 10% to 15% drop in a stock price during a single trading day is not uncommon. If a stock falls 10% due to poor quarterly results, guidance or bad news, that should not be mistaken for "market noise". These kinds of drops are followed by steadily gradual decline until buyers start to come back in the stock and this could go on for as long as 3 to 12 months. An event like this is a prime opportunity to open up a short position or even better, buying puts one to two months out in future.