Trader Dynamics Toolkit: Noise trading

The massive moves in oil in the past days made me wonder why loads of people sit and stare at the multitude of indicators on their screen all day. If you look a bit further back you will see oil  has been moving for a couple of weeks, quite significantly. If you search in Google you will notice that there were stories about ISIS and Iraq and the impeding crisis around the same time.  Suddenly, you have a neural trading system, which would normally cost, you an arm and a leg. But this kind of trading based on noise is age old.  Even  Edwin Leferve read the ticker and made quick trading decisions based on it in the 1920's

There are all sorts of labels for Traders based on what time-frame and system they use to trade. Everyone has heard of the swing trader and day trader or position trader. In my many searches on the web I discovered a label for a trader I had never seen before. Noise Trader.  Actually, it was coined in a report written by Andrei Shleifer and the famous Lawrence H Summer  titled “The Noise Trader Approach to Finance” . Link at the bottom of the page for your information.

Many of you think I am mad to think that a 21-year-old document has any relevance to modern-day trading. I agree its all pretty boring until you get to page 28 and positive feedback trading. “The key to success, says Soros, was not to counter the irrational wave of enthusiasm, about conglomerates, but rather to ride this wave for a while and sell out much later.” It goes on to say that this could lead to a bubble but can make you very rich in the short-term. Even back then they were scared of the noise traders as they suggest taxing them to the hilt. Well 20 years later and after a series of bubbles nothing much has really changed.

I guess that means all great traders are noise traders. Now to me that makes perfect sense. The false prophets and market Gurus that peddle indicators and mechanical systems inherently dismiss the one real mover of markets, Sentiment. Yes, some people say much of this is built into the market and I totally agree, if you are a high frequency trader, but most of us are not. For them lagging means a millisecond for us it could be hours or days. It is not bad if you want to make a few great trades, but to be a real trader you need consistency. That means trading well, most days for  years. The only way to do that is to follow the successfull crowd, and follow it as perfectly, as you can.

So the question comes down to how one measures noise and sentiment in the markets. Most of trading these days is done by machines and even in dark pools where there is no transparency. The few indicators for momentum are based on the price anyway and are pretty much useless. A friend was following sentiment based on his Twitter posts. That is not a bad idea but its a bit like standing outside a football stadium and predicting the results based on the crowd cheering. You will get it right sometimes but you would be blind, literally.

The answer to all this is very much in built in the strategy. There are a host of analogies traders use, riding the wave, jumping on the bandwagon,and buy low, sell high. The implication for these statements is a fundamental shift in a market, towards a certain direction. Too many traders, these days want to know the whys and the how's. None of that is relevant.

The real questions are  ”is the market moving ?” and “why aren’t you in it ?”

The Noise Trader Approach to Finance
http://scholar.harvard.edu/shleifer/files/noise_trader_approach_finance.pdf

Contrarian Trading: Where perception meets reality

The moves in the market, now, reflect an interesting market dynamics. The Euro-zone continues under performing and the US economy is sputtering to life. The hype surrounding economic recovery  is  based on a market perception that has been fed with European and Japanese financial stimulus and US Quantitative Easing.  As the US starts to  taper the Euro-zone picks up the baton and runs the  printing presses at maximum speed.  Things are not right economically , but we follow the traders not the economists.  Economists and politicians love a nice bull run.  Traders don't  care as long as something, somewhere  is moving.  

Markets  are about perception, much of it is not real or connected to reality. The futures market is exactly that, a perception of the future. There are many perceptions of the future. Which is why people bet against each-other. You cannot compete with someone else’s perception of the future, you have to create your own. Furthermore, even though individually people tend to be rational we have seen, in history, as a group they become completely whimsical. The psychological make-up of the market is more akin to a panicky impulsive 4-year-old then a grown up.

If you follow the US market all you have to do is look at the S & P or Dow. The Dow regularly falls over 100 points and regains it based on the flimsiest pieces of news and conjecture. In the modern era where 60 % of trades tend to be through computers and neural networks trading has become much easier.  People may pretend that these algorithms are super complex but the reality is that most of them just look at the prices of a few different instruments and some key Twitter accounts. They look at correlations between certain markets and also filter out key keywords from news sources and then place trades automatically. 

They react. They are not really neural and clearly cannot predict much. In fact their power of prediction is far worse then human traders. However, they trade better because all the emotions associated with human traders have been taken out of the equation. 

It is true, there are the High Frequency Traders and some people who are privy to inside information, but that is nothing new. If anything,  inside information is pretty useless as one cannot predict how the market will react to it. Good news can be bad market and so forth. So how does one trade against these mechanical monsters ?

It is pretty clear if you are a regular market follower. The old adage about trends being your friend is great if you are trading on the daily, weekly and monthly charts.  A yearly chart of the US/Yen looks very tradeable but on the smaller time frames this is madness.

High Frequency algorithms, neural networks are inherently linked to the human psyche but magnify our emotional problems. They panic buy and panic sell based on a few keywords. They muddle up correlations between currencies because the people who design them hide behind formulas and equations not the truth about markets. It is for this reason that, after the sub prime crisis, the human traders in hedge funds have a habit of turning them off and trading manually when things heat up.

Do your research, and use your system but when the market goes crazy don’t blame it on the computers, dust off one of your nice contrarian strategies and make money. There are many effective strategies based on divergence. Once you start using them you will see divergence everywhere.

Trading divergence is the modern betting against the panic. It is a tough call and not for the faint hearted but as Hyman Roth said in the Godfather II when his associate Moe Greene got a bullet in the eyeball: And I said to myself, this is the business we've chosen.

The Grey Zone

This has been  a month of  great moves. All month the financial media has been talking up a massive fall in the US markets yet the SP and Dow have been racking up record after record. How do we reconcile the vast ocean that separates perception and reality ? We have been told  every day that traders  are shorting the market, yet 100s of points later the market is still rising and will most likely continue to climb.

This is a  phenomenal  learning curve to experience for any trader that sincerely believes the rubbish that comes from analysts and financial  journals.  The market will eventually  fall but in the interim it will  wipe out every short contract in iits way. Believing in the hype and calling tops or bottoms and preempting changes  in market  direction is a brokers wet dream. No sane person attempts that unless they have vast amounts of margin capital or  inside information.

In the age of computers, algorithms  and vast  permutations the simple  trader that trades accounts under 10 million dollar is safer  following the market. He gives up a few  pips at the top  and a  few pips  at the bottom but  he makes  that up in not getting snowballed for weeks on end my  market makers that are happy raking in massive amounts  of margin calls on short positions.

The Noise trader approach where you  piggy back on the larger market moves and stay in as long as you can until there is a turn in sentiment has been the preferred trading method for many of the most succcessful traders.  In fact it was so effective the famous Mr Summers wrote a paper about it.  Check out the paper below on Noise trading. And see if it works for you.


The Noise Trader approach to Finance
How Noise Trading Affects Markets: An Experimental Analysis