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Noise trading refers to a style of investing in which decisions to buy and sell are made without the use of fundamental data specific to the company that issued the securities that are being bought or sold. Noise traders generally make short-term trades to profit from various economic trends.
While technical analysis of statistics generated by market activity, such as past prices and volume, provides some insight into patterns that can suggest future market activity and direction, noise traders often have poor timing and overreact to both good and bad news.
Even though that description may not sound very flattering, in reality, most people are considered to be noise traders, as very few make investment decisions solely using fundamental analysis. To put this style in perspective, let’s revisit our earlier analogy about a trip to the mall. Unlike the fundamental analyst, a technical analyst would sit on a bench in the mall and watch people go into the stores. Disregarding the intrinsic value of the products in the store, the technical analyst's decision would be based on the patterns or the activity of people going into each store.
Technical analysis, like other strategies that involve data analysis, can be time-consuming and may require quick reactions to take advantage of perceived opportunities.
Sentiment traders seek to identify and participate in trends. They do not attempt to outguess the market by finding great securities. Instead, they attempt to identify securities that are moving with the momentum of the market.
Sentiment traders combine aspects of both fundamental and technical analysis in an effort to identify and participate in market movements. There are a variety of sentiment trading approaches, including swing traders that seek to catch momentous price movements while avoiding idle times and contrarian traders that try to use indicators of excessive positive or negative sentiment as indications of a potential reversal in sentiment.
Trading costs, market volatility, and difficulty in accurately predicting market sentiment are some of the key challenges facing sentiment traders. While professional traders have more experience, leverage, information, and lower commissions, their trading strategies are restricted by the specific securities they are trading. For this reason, large financial institutions and professional traders may choose to trade currencies or other financial instruments rather than stocks.
Success as a sentiment trader often requires early mornings studying trends and identifying potential securities for purchase or sale. Analysis of this nature can be time-consuming, and trading strategies may require quick timing.
Market timers try to guess which direction (up or down) a security will move to profit from that movement. They generally look to technical indicators or economic data to predict the direction of the movement. Some investors, especially academics, do not believe that it is possible to predict the direction of market movements accurately. Others, particularly those engaged in short-term trading, take the exact opposite stance.
The long-term track record of market timers suggests that achieving success is a challenge. Most investors will find that they are not able to dedicate enough time to this endeavor to achieve a reliable level of success. For these investors, long-term strategies are often more satisfying and lucrative.
Of course, day traders would argue that market timing could be a profitable strategy, such as when trading technology shares in a bull market. Investors who purchased and flipped real estate during a market boom would also argue that market timing could be profitable. Just keep in mind that it’s not always easy to tell when to get out of the market, as investors that got burned in the tech-wreck crash and real estate bust can attest. While short-term profits are certainly possible, over the long term, there is little evidence to suggest that this strategy has merit.
You could be more than one type of trader or none of these, depending on your personality.
Arbitrage traders simultaneously purchase and sell assets in an effort to profit from price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies—it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. This type of trading is often associated with hedge funds, and it can be a fairly easy way to make money when it works.
For example, if a security trades on multiple exchanges and is less expensive on one exchange, it can be bought on the first exchange at the lower price and sold on the other exchange at a higher price.
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