In the lexicon of technical analysts, professional traders and investors, there is such a thing as market noise. In this article, we will thoroughly understand what kind of noise is, how it can be dangerous for a trader and what effective methods of filtering it exist.
Market noise by examples
So first, let’s take a look at these two graphs:
As you can see, they represent the same financial instrument (GBPUSD currency pair) on different timeframes. On the first chart, the one-minute timeframe is selected (each candlestick corresponds to one minute), and on the second, the daily timeframe (each candlestick represents the price change for the day).
Pay attention to the size of the candles. As you can easily see, on the minute chart (M1) both the candlestick bodies themselves and, which is typical, their tails, look relatively large, which indicates a large amplitude of price fluctuations within each of them. As for the daily chart (D1), both the bodies and the tails of the candles look noticeably more compact on it.
So, on the first chart (M1) the level of market noise is noticeably higher than on the second.
Market noise is usually called short-term price deviations from its main direction of movement.
That is, if the price development occurs within a certain trend (be it an uptrend, downtrend or flat), then each step of the price “to the side” can be considered as price (market) noise.
For ease of understanding, here are a couple more pictures for you:
They depict two trajectories of price movement: ideal and real. So the real differs from the ideal precisely in the presence of price noise.
Of course, there can be no ideal price movement. And the line that determines the presence of market noise is very conditional. It should be understood that this concept is quite subjective.
The Root Causes of Market Noise
Noise is inherently chaos, it appears as a result of chaotically (haphazardly) directed market forces formed as a result of all the multitude of orders, orders, limit and stop orders that constantly appear in the market for this particular financial instrument.
As you probably know, the current market price is nothing more than an equilibrium result of the forces of supply and demand (in this case, buy and sell orders). And, accordingly, if these forces are not constant values, but, on the contrary, constantly fluctuate (which is generally characteristic of a market economy as a whole), then the result of their interaction – the current market price – will inevitably fluctuate.
Well, fluctuations in supply and demand, in turn, are due to the fact that the bulk of exchange players (traders, investors and others like them), oddly enough, tend to haphazardly placing orders. However, this is mainly due to purely psychological reasons (the banal fear of getting a loss or missing out on profits).
After all, whatever one may say, but the price in the market is made by living people who are not alien to such properties of human nature as fear, greed and hope. It is these types of emotional state that are the three heads of the mythical serpent Gorynych, spewing flame from their throats, burning potential profit, and after that the deposits of traders. Read more about this here: “Psychology of Trading. Trader’s fear, greed and hope ”.
The market is generally characterized by periods of uncertainty, when at the same moment of time some traders hold unprofitable positions in the hope of a price reversal, some close positions in fear of losing the profit that has barely run into it, some keep their positions “to thaw” out of greed to miss at least one point of profit (and as a result, after a price reversal, they lose most of it). Many people open at all at random and only the most experienced people prefer to wait out such periods, remaining out of the market all this time.
All this haphazard mess, not subject to any intelligible logical laws, generates the very chaos, as a result of which the price is constantly scouring up and down, forming the current market price, and, along with it, the notorious market noise.
What is the danger for a trader
Let’s make a reservation right away that market noise can be dangerous only for traders engaged in short-term trading (intraday), and especially for scalpers shaking over each profit point. For those who trade in the medium and, even more so, in the long term, market noise has practically no meaning. In general, with an increase in the timeframe of the charts used in trading, the influence of market noise steadily tends to zero (you can take another look at the very first figure with two charts M1 and D1).
Basically, if your minimum working timeframe starts from H4 (four-hour chart), then you hardly have to bother about this kind of noise. Trade in the long term and you will be profitable.
If you trade within the day and use small timeframes (М1, М5, М15) for analysis, then there is a high probability of making erroneous decisions based on false signals that your trading system will give in a multitude (precisely because of this kind of noise) or separately taken indicators.
As mentioned above, the border of the market noise is a rather subjective value, moreover, the smaller the timeframe, the more pronounced this noise is. Therefore, it is far from always possible to distinguish the true price movement (at the beginning of a new trend) from simple volatility within the price noise. Well, this, in turn, can be fraught with such consequences as:
- Knocking out Stop Loss orders, followed by a price reversal;
- Early triggering of pending limit and stop orders;
- Panic in the actions of the trader and the erratic placement of orders for buying and selling, first in the hope of catching a new trend, and then in attempts to win back the losses incurred in such throwing.
Basic methods of filtering market noise
In order to filter out noise from the price chart, the following basic methods are usually used:
- Smoothing prices with small moving averages;
- Presentation of prices on “Renko” or “Point and Figure” charts.
Using Moving Average
Below is an example of a price chart with a moving average plotted on it:
As you can see, thanks to this technique, you can easily filter out all unnecessary noise. In this case, the lower the order of the average is, the more accurately it will repeat the trajectory of the price movement, but it will also cut off less noise.
This method has one significant drawback, the MA tip has a very unpleasant property to constantly redraw. That is, the shape moving along its entire length remains unchanged, but its very end follows the price until the next bar (candlestick) is in the formation stage. When the bar finally takes its final shape, the corresponding segment of the moving line also freezes in eternity, however, its continuation corresponding to the new bar appears and everything repeats again.
This drawback is fraught with the fact that the trader sees a somewhat distorted picture of the development of the price trend, and because of this, there is a risk of receiving false signals, for example, such as breakout signals of various levels and support / resistance lines.
Using charts like “Renko” and “Tic-tac-toe”
There are such types of charts in the arsenal of technical analysts, the very principle of their construction excludes the presence of any echoes of market noise on them. These include, for example, the well-known “Renko” and “Tic-tac-toe”.
Renko consists of black and white bricks of a given height, but tic-tac-toe … (by the way, of course, you guessed it). Both assume the drawing of each new chart element only when the price passes a specified number of points. That is, it turns out that all sorts of small price movements (constituting the very noise) are simply not taken into account.
The principle of Renko charting is as follows:
- To begin with, the type of price at which the chart will be built is selected (based on open, close, maximum or minimum prices). Usually use the closing prices (Price Close);
- Each new white brick is drawn strictly diagonally upwards only after the price rises by the threshold in points specified in the chart settings (for example, every 20 price points);
- Each new black brick is drawn diagonally downward only after the price falls by the specified threshold value.
Here is a sample Renko chart using Tesla stock as an example:
And here is the same graph (for the same period of time) presented in the usual form:
Agree that the first option is much more informative and more specific in terms of identifying clear market trends. The periods of growth (upward diagonal of green bricks) and price declines (downward diagonal of red bricks) are very simply and precisely expressed on it. In total, seven such periods have been identified during the year. Everything is concrete and simple.
And here is the same graph, but already presented in the form of tic-tac-toe:
Everything here looks even more compact and simple, doesn’t it?
By the way, there is an interesting and useful article on this type of chart: “Market Analysis Using a Point and Figure Chart”