How to Trade Without Market Noise

Reviewed by Gordon ScottFact checked by Suzanne Kvilhaug

Removing market noise is one of the most important techniques for active trading. By employing noise-removal techniques, traders can avoid false signals and get a clearer picture of an overall trend. Here we take a look at different techniques for removing market noise and show you how they can be implemented to help you profit.

Key Takeaways

• Market noise is price data that obscures or distorts the clarity of an underlying trend.
• Using noise reduction techniques can help investors more clearly determine the strength and direction of an underlying trend.
• Popular noise reduction charts, such as the Renko, Heikin-Ashi, and Kagi charts, provide a smoother picture of trend direction.
• Market indicators such as the directional movement index and its derivative, the average directional movement index, show trend strength.
• Combining a noise-reduction chart with a trend strength indicator can help investors avoid costly mistakes due to false signals.

What Is Market Noise?

Market noise is all of the price data that distorts the picture of the underlying trend. This includes many small corrections and intraday volatility. To fully understand this concept, let’s take a look at two charts – one with noise and one with noise removed.

Before noise is removed:

After noise is removed:

In the first chart, is often difficult to identify whether the trend is changing on some days. Compare that to the second chart, in which there are no longer any areas in which the trend is not easily seen.

The technique used in the second chart is averaging: locating where the current candle factors in the average of prior candles, then using that data to create a smoother trend. This is the aim of noise reduction: to clarify trend direction and strength.

Determining these two factors—strength and direction—and combining them allows you to create reliable charts in which the behavior of a trend is easier to read.

Important

Removing the noise to obtain a clearer perspective on the underlying trend can be an important step in executing a profitable trade. To learn more about developing your trading strategy, check out the Technical Analysis course at the Investopedia Academy, which includes video content and interactive examples to help you become a more effective trader.

Isolating Trend Direction

Isolating trend direction is best done through the use of specialized charts designed to eliminate minor corrections and deviations. Once these are removed, the chart should only show larger trends. Some of the charts (such as the second chart above) simply average prices to create a smoother chart; others completely recreate the chart by considering only trend-affecting moves.

Renko Charts

One example of a chart type that only uses trend-affecting moves is the Renko chart, named after the Japanese term renga (brick). Renko charts isolate trends by taking price into account but ignoring time.

They are created by using a simple four-step process:

1. Choose a brick size. This is the minimum price change required for a new brick to appear.
2. Check whether the current day’s close is above the high or below the low of the previous brick.
3. If the closing price is higher than the top of the previous brick by at least the size of one brick, one or more bricks are drawn in the next column, depicting an upward move in direction.
4. If the closing price is lower than the bottom of the previous brick by at least the size of one brick, one or more bricks are drawn in the next column depicting a downward move in direction.

Note that green bricks are drawn for prices advancing above the previous high, while red bricks are drawn for prices falling below the previous low. Let’s take a look at an example:

As you can see, it is much easier to identify trends on these charts than on traditional candlestick charts. Further noise reduction can be obtained by increasing the size of the bricks.

Warning

Increasing brick size will also increase the intra-trend volatility. You will need to have enough capital to withstand this volatility.

Overall, Renko charts provide an excellent way to isolate trends, but they are limited by the fact that they don’t provide a way to determine trend strength other than simply looking at the trend length, which can be misleading.

Heikin-Ashi Charts

The second type of chart that can be used for noise reduction is the Heikin-Ashi chart. These charts use a strategy similar to the first two charts—they factor in the current bar with an average of past bars. This process creates smooth price patterns that are easy to read.

These are the charts most commonly used when reducing market noise, and they can easily be used with other indicators. Another added benefit is that they also smooth out the indicator because the price bars are used as indicator inputs. This can help make indicators far easier to read. 

Kagi Charts

Kagi charts are designed to show supply and demand through the use of distinguished lines. New lines are created whenever a new high or low is established. By isolating highs and lows, it becomes much easier to see the larger trends.

Let’s look at an example:

Trending times in a Kagi chart are defined as times when demand exceeds supply (uptrend) or supply exceeds demand (downtrend). Finding trends becomes as easy as looking for distinguished lines.

These charts are also excellent for noise reduction. They are limited because they can’t determine trend strength other than by measuring the move lengths, which can be misleading.

Determining Trend Strength

Trend strength is best gauged through the use of indicators. For the purposes of this article, we will take the popular indicator directional movement index (DMI), as well as its derivative, the average directional movement index (ADX).

The DMI indicator is the most widely used trend strength indicator. This indicator is divided into two parts: +DI and -DI. These two indicators are then plotted to determine overall trend strength.

The ADX indicator is simply the averaging of the two DMI (directional movement index) indicators (+/-) to create a single line that can be used to instantly determine whether a price is trending or dormant.

Let’s see an example of how this can be useful:

As you can see, the slope increases at a greater rate when the trend is stronger and at a lesser rate when the trend is weaker. Typically, the ADX is set at a 14-bar range, with 20 and 40 being the two key points. If the ADX is rising above 20, it signifies the beginning of a new trend. If it rises above 40, that means the trend is likely about to end. As you can see from the chart above, it can give you a fairly accurate read.

Creating a Usable Strategy

Although the ADX appears to work well on its own, market volatility can cause second-guessing and false signals. However, when combined with chart types that more easily highlight trends, it becomes a lot easier to identify profitable opportunities.

Using a combined analysis is as simple as determining whether the chart pattern’s sentiment is the same as the indicator’s sentiment. Therefore, if you are using Heikin-Ashi and ADX, simply check to see what the trend direction is on the chart and then take a look at the trend strength shown on the ADX. If both are telling you that there is a strong trend, then it may be a good idea to enter.

Here’s an example:

Here we can see that the trends are smoothed out by the use of averaging techniques (like Heikin-Ashi) and are being confirmed through the use of indicators (like ADX). This gives us a clear and reliable picture of the current market situation, without any unnecessary clutter (market noise).

What Are False Signals in Trading?

False signals are signs that indicate a future price movement but don’t accurately reflect the current economic picture. They are misleading signals that appear in technical analysis, often due to factors like market noise, time lags, or irregular data.

What Is the Difference Between a Candlestick Chart and a Kagi Chart?

A candlestick chart shows the high low, opening, and closing prices for each trading day. It doesn’t include most of the market noise from price fluctuations over the course of the day. A Kagi chart only shows changes in direction when the price movements reach a certain size. In a Kagi chart, movement past a previously established high or low is shown by a change in the thickness of the lines or the line’s color.

Why Should Market Noise Be Removed?

Market noise can provide false signals, leading to trades that aren’t based in the economic reality of an asset. The price of a security can fluctuate many times over the course of a day, but most of these movements don’t indicate a change in the market value of the security. These fluctuations can lead inexperienced traders to think a new trend is starting, when in reality the price of the underlying security will correct before the end of the day.

The Bottom Line

When it comes to investing, chart analysis is much easier when using noise removal techniques. Combining a noise-reduction chart, which shows a trend’s direction, with an indicator that shows the trend’s strength can help you avoid costly false signals and other mistakes. This will allow you to quickly and accurately locate and capitalize on trends.

Read the original article on Investopedia.