UNIT II

NOISE TRADER RISK

Noise Trader is mainly intended to describe investors who make decisions to buy or sell
based on factors they believe to be helpful but in reality will give them no better
returns than random choices. Noise Trader Risk is a form of investment risk associated
with the decisions made by so-called noise traders. The higher the volatility in market
price for a particular security, the greater the associated noise trader risk—that is, the
risk associated with largely uninformed traders who trade on the noise in the market
instead of the signal.
Behavioural finance researchers have attempted to isolate this risk in order to explain
and capitalize upon the sentiment of the majority of investors. Noise trader risk is
assumed to be more readily found in small-cap stocks, but has also been identified in
mid- and large-caps.
Also, as the media pumps out more and more content, there tends to be more headline
risks for stocks and markets. The noise can sometimes move stocks and markets in the
near-term. However, it is important to understand that some noise is designed to stir
emotions. Emotions are typically not always a good indicator for investors.
 Understanding a Noise Trader

Conventional wisdom posits that noise traders are considered to be substantial contributors to high-
volume trading days because it is thought that these traders are making irrational decisions and
responding emotionally. However high-volume trading days are inevitably driven by institutional investors
who are among the most informed and should be making the most well-researched investing decisions.

The category of traders that are stereotyped as noise traders includes novices and those who trade primarily
based on technical analysis. However, those who don't trade the market averages and instead follow trading
systems that under perform the market, regardless of the factors involved, should be lumped into the same
category.

Some professional analysts and academics like to say that noise traders overinflated the price of
securities in bullish trading periods and depressed the price of securities in bearish trading. For mainstream
investors, these affects can be known as noise trader risks. Noise traders thus cannot affect prices too much, and
even if they can will not do so for long.

Edwin Burton and Sunit Shah introduced the concept of the Noise Trader agenda to help better frame a
discussion of noise traders. This concept was published in their text titled, "Behavioral Finance," (Wiley, 2013)
and it is further quoted in the CMT Association's Level I Exam book.
Example1
The risk of a loss on an investment that comes from a noise
trader. A noise trader is an investor who makes decisions based on feelings such as fea
r or greed, rather than fundamental or actual
technical changes to a security. If enough noise traders panic, they can drive down the
price of the security unnecessarily. Suppose an investor owns 1,000 shares of a stock
and they are currently at $50 per share. If noise traders overreact to bad news, the pri
ce could drop to $40 per share without any fundamental justification. This costs the in
vestor $10,000. The possibility that this could happen is noise trader risk.
Example 2
As an example, an informed trader may have a model that suggests the value of XYZ
shares is $10, but due to a piece of bad news in the media, the stock is now oversold
by noise traders, with shares trading down to $8. The smart analyst believes that the
negative news story should only move the expected value down to $9.90, but despite
this, the noise traders dominate the market activity, at least in the short run. This risk
implies that even well-informed or rational traders can be undermined by the
irrationality of the crowd.
At the same time, if a patient smart money investor is able to understand the noise
trading risk, he or she can buy the stock when it is at $8 with confidence that it should
soon rise.
If the noise trader risk for a particular stock is high, an issuance of good news related
to a particular company may influence more noise traders to buy the stock, artificially
inflating its market value.