Follow the Smart Money

Follow the Smart Money

 

Smart money in the financial markets is considered to be capital traded or invested by experienced and educated professionals that are connected to better research on fundamentals or access to higher speed technology that gives them a technical edge over retail traders. There is little evidence to support the smart money edge as the majority of hedge funds and mutual funds underperform their benchmark indexes. However their large amount of capital, their beliefs, and actions can move charts due to inflows and outflows of their funds.

 

The smart money is believed to have more knowledge and inside information than the general public. Following the smart money is thought to give an investor or trader a higher probability of success when trading the patterns that institutional investors create.

 

Support and Resistance Levels

 

Support and resistance levels can be created on a chart by smart money during accumulation or distribution cycles in the market. During a range bound market as smart money buys key price levels they want to build a position at it can create horizontal support. They can also create resistance levels if they want out of a position so they sell at a high price each time it is reached and create a distribution level. In uptrends, smart money can create vertical support by buying dips to a key technical like the 50-day moving average as they add to their long term positions. During downtrends smart money can create vertical resistance as they sell into strength on each rally backup to the 200-day moving average as they try to get out of large positions over time. High volume buying and selling around key technical levels can create support and resistance as smart money picks their levels.

 

Volume

 

Volume on a chart is the financial footprint that smart money leaves as it accumulates or distributes large positions in a stock. Smart money generally has size so it can’t get in and out quickly without moving the market. Large volume far above average should be present on a chart during a breakout in price if smart money has started to accumulate a stock. At market tops and bottoms large volume should show up at price turning points as the chart reverses in the opposite direction as smart money begins to exit near tops or buy near bottoms.

 

Institutional Ownership

 

Institutional sponsorship is the amount of ownership of a stock by professional money managers like mutual funds, banks, pension funds and large financial institutions. These managers spend a lot of money on teams of analysts that research the stock market looking for value, growth, and consumer trends. Seeing the institutional ownership grow quarter over quarter is bullish for a stock as it shows accumulation into strong hands. This also creates liquidity in the stock as you know you have buyers waiting to get in. Institutions are suppose to be the smart money in the market.

 

Smart Money Flow Index

 

Smart money flow index or smart money index (SMI) is a technical analysis indicator that attempts to show the current market sentiment of investors. The index was created and made popular by Don Hays, who was a money manager. The SMI indicator uses intraday price patterns to measure bullish or bearish sentiment.

 

The SMI indicator is based on the theory that many traders are both emotional and react strongly to overnight headlines and new economic reports at the beginning of the trading day in the futures market, pre-market , and the opening bell. At times there is high volume buying with market orders and short covering at the opening bell in the stock market that can show investors and traders overreaction in the morning. The basic strategy using the smart money flow index is to trade against the morning price move and trend and trade with the evening price trend. The SMI can be calculated for several markets and market indices like the S&P 500 and Dow Jones Industrial Index.

 

The basic SMI formula is:

 

Today’s SMI reading = yesterday’s SMI – opening gain or loss + last hour change

 

One example is if the SMI closed yesterday at 10,000. During the first 30 minutes of today’s trading, the Dow Jones Industrial Index has gained a total of 100 points. During the last hour, the DJIA has lost 80 points, today’s SMI is 10000 – 100 + -80 = 9820.

 

The smart money flow index shows no clear signal if a market is bullish or bearish. It has no fixed absolute signals for the direction or momentum of the current trend. SMI dynamics have to be looked at in current relation to the market behavior. If the SMI goes up a lot when the market drops, this could mean that the ‘smart money’ is buying, and the chart could be ready to move higher. The inverse is with a rapidly dropping SMI in a bullish market it could mean that the ‘smart money’ is selling and that the chart could be ready to fall lower. The SMI is a trend indicator within the context of current price action. This indicator was designed to be used on daily charts only.

 

Commitment of Traders Report (COT)

 

The Commitments of Traders or COT report is a weekly report created by the Commodity Futures Trading Commission (CFTC) quantifying holdings in the U.S. futures and options contracts by different market participants. It is put together by the CFTC from traders disclosures of market positions and covers the futures on grains, cattle, financials, metals, energy, and other commodities along with options.

 

The CFTC issues a new report every Friday at 3:30 p.m. EST, and it reflects the commitments of traders on the previous Tuesday.

 

The COT report shows a summary of aggregate positions held by traders of different sizes that are classified as one of three types: commercial traders, non-commercial traders and non-reportable. Commercial traders are usually hedgers, buying or selling future contracts to hedge their company’s product. Non-commercial traders are many times large speculators like hedge funds, CTAs, or big money traders trying to profit from price action, fundamentals, or macro trading with little or no underlying interest in receiving physical commodities on delivery. The nonreportable group are thought to be almost all small speculators trading a few contrats trying to profit from short term price moves.

 

Many traders use the COT report to see how smart money and big money are positioned to help see the big picture of the trend and the possibility of it reversing. The report can be one filter speculators use to decide the direction they should take positions in whether long or short. One popular trading method is that small traders are the ‘dumb money’ and are usually wrong and the best odds of success is to position against the total net non-reportable positions direction. The other commonly held belief is that the commercial traders are the ‘smart money’ as they are experts in their commodity, industry, and market so it is best to trade in the same direction as their overall positions.

 

When using this report, traders should be very aware that it can take time and multiple attempts to benefit from attempting to fade a trade and go against or with either group. It is best used as a big picture view of the sentiment of different groups of traders and has value when used in confluence with other trading signals.