The term “noise” is often used in day trading. Whenever traders mention noise, they typically mean price behavior that seems unreasonable, erratic and hard to trade. But does noise really exist or is it one of those trading myths that have become common knowledge because the majority of traders do not understand the implications of it?
We want to explain why noise is not an actual trading concept; it does not exist and what most traders mistake for noise is actually a price environment that should be avoided – we show you how.
Noise vs. no noise
Before we get into the details on how to avoid noise, we have to be clear what traders mean when they talk about noisy price action. Typically, fake breakouts, whipsaw price action going back and forth, candle spikes and immediate reversals is what traders mean when they talk about noise. Trading in such an environment is indeed challenging, but traders can easily avoid such periods as we will see later.
On the other hand, the preferred price environments are high momentum phases where price trends smoothly, when you see clean technical moves around well respected technical levels and smooth transitions from consolidations into trending phases.
Chart Courtesy of TradingView
Understanding noise I: Low probability periods
The first mistake traders make is that they don’t know when not to trade. The good traders know to differentiate between times when they have an edge and the other times when markets don’t offer high probability trading scenarios.
The first step is knowing your trading strategy and understand its premises. A trend-following trader has to know how to identify high momentum environments. A breakout trader has to be able to identify consolidations that have a high chance of seeing a successful breakout and a reversal trader has to look for overextended trends. Thus, you have to learn how to identify the optimal trading environment for your trading strategy.
Amateurs have the urge to trade at all times and then get caught in situations where they don’t have an edge.
Understanding noise II: Low probability price areas
After a trader understands how to identify the overall market environment that his trading strategy favors, he has to identify high probability price areas to increase his chances of success even further. It’s not enough to find a high momentum phase and then blindly enter a trade. You have to identify price levels that allow you to increase your odds of placing a potentially profitable trade.
Typically, traders use trendlines, horizontal support and resistance, Fibonacci levels, moving averages or other technical concepts to create confluence and identify potential trade areas. If you are a trend-following trader, you need to find levels where price transitions from a range into a new trend; as a range trader, you have to identify price levels of strong support and resistance that make for reasonable turning points and a reversal trader has to look for areas where an ongoing trend is likely to reverse.
A trader who knows how to avoid periods when the general market environment does not support his trading system and also understands how to identify high probability price areas, can avoid a lot of market noise which are actually just times when you don’t have an edge.
How to avoid “noise” – knowing when not to trade
Now you should have a better understanding of what most traders view as noise and why it typically just describes trading during the wrong times. We can then review tools and concepts that can be used to avoid trades where you don’t have an edge:
- Know your system
We have already mentioned it, but understanding the premise of your trading strategy has to be your top priority. Being clear when you have an edge and knowing how to identify markets environments that don’t support your approach is of great importance.
- Momentum and trend
Tools that can be used to identify trending and high momentum phases are Bollinger Bands, a two moving averages trading method or the analysis of raw market highs and lows.
When price trends higher, along the outer Bollinger Bands, it typically signals a strong trend – when you see price going back and forth around the middle Band, you are in a range market. The space between two moving averages, describes the momentum (click here to read more) and when markets don’t respect moving averages, you are in a low momentum phase.
Chart Courtesy of TradingView
- Creating confluence
Confluence is an important concept in trading and it helps significantly when looking for high probability price areas. Trendlines, horizontal lines, Fibonacci retracements and other chart studies that intersect can point to price levels where you have a better edge.
- Avoid market uncertainty
This point is very relevant these days. Current markets have a lot of volatility, the VIX is at a high level and markets frequently shift between risk-on and risk-off periods. The level of uncertainty is very high which leads to a lot of volatility and sharp reversals. The greatest advantage retail traders have is that they don’t have to trade. Constantly looking for the next trade won’t do you any good. The skill of patiently waiting until you see a high probability trading scenario is among the most important skills a trader has to master.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.
