The terms “smart money” and “dumb money” are used to describe different groups of market participants. Institutional investors and market insiders are labeled “smart money”, on the other hand, small retail traders and short-term speculators are labeled “dumb money”. Dumb money tends to buy and sell at the worst possible time, and it is wise to trade against it.
What is smart and dumb money?
There are many ways to define smart and dumb money in the global financial markets. Generally speaking, smart money refers to investments made by people with expert knowledge of the market. These experts may be successful hedge fund managers, wealthy individuals, or even insiders who have access to illegal inside information. On the other hand, dumb money mainly refers to retail investors who have limited knowledge of the market. Dumb money tends to follow exhausted market trends by applying high capital leverage. In many cases, small speculators and leveraged traders are usually referred to as ‘dumb money’.
According to statistics in a two-decade period, the average retail investor performed 2.75% less than the generalmarket (each year). The following analysis focuses on several tools that can help traders identify the movements of smart and dumb money.
- The goal is to position in line with Smart Money (hedge funds, institutional investors, market gurus, insiders) andcontrarian to Dumb Money (retail traders, leveraged traders, small speculators)
(1) Monitoring the weekly COT Report (All Financial Asset Classes)
An easy and practical way to monitor the positions of smart and dumb money is through the COT report. The COT or Commitments of Traders report is a weekly analysis that depicts the total positions of different players in the US derivatives market. The report includes all major asset classes: commodities, Forex currencies, stock indices, and even cryptocurrencies.
Major changes in the positions of specific categories of participants can signal upcoming trend reversals. These are three key categories of players involved in the COT report:
(a) Asset Managers
‘Asset Managers’ include institutional investors such as mutual funds, pension funds, and insurance companies, but also portfolio managers whose clients are mainly institutional investors. A major change in the positions of ‘Asset Managers’ can be an interesting clue in the COT report.
(b) Dealers
This category is the 'sell side' of the futures market and includes participants such as major banks and stockbrokers. Dealers use the futures market to hedge their portfolio risk, therefore, their role in the market is quite complex.
(c) Leveraged Funds (Dumb Money)
‘Leveraged Funds’ include players who seek capital leverage on their behalf or on behalf of some of their speculative clients. This category is usually wrong and may be seen as the ‘Dumb Money’ of the COT report.
Tip:
You want to trade contrarian to ‘Leveraged Funds’, especially when the positions of the other two participants coincide in the opposite direction.
Links:
More about the COT report on TradingCenter.org
(2) Smart Money Flow Index (Equities)
The ‘Smart Money Flow Index’ or SMFI aims to record the market behavior of smart and dumb money. The SMFI was developed in 1997 by R. Koch (WallStreetCourier) and it is based on the Don Hays’ ‘Smart Money Index’. In 2003,Bloombergpublished the SMFI indicator on their terminals.
Calculations
The ‘Smart Money Flow Index’ focuses on Dow Jones industrial and calculates two key trading periods:
Opening (shortly after the Dow opening)
Closing (within the last hour of trading)
As mentioned before, the SMFI is based on the ‘Smart Money Index’. The SMFI formula is not publicly available, however, the Don Hays SMI formula is as follows:
(a) Dow Jones Industrial gain or loss (in points) after the first half hour (9:30 a.m. - 10 a.m. EST)
(b) Dow Jones Industrial gain or loss (in points) during the last hour (3:00 p.m. - 4:00 p.m. EST)
(c) SMI = yesterday’s Smart Money Index - today’s gain/loss in the first half hour + today’s gain/loss in the last hour
Utility (on DJIA)
Recognize and confirm strong market trends
Identify major support and resistance levels
Identify divergences between the slope of SMFI and the slope of Dow Jones Industrial (can be used as an early sign of a trend reversal)
Chart: SMI on Dow Jones Industrial (weekly)
Tip:
The ‘Smart Money Flow Index’ can prove an interesting tool when investigating the possibilities of a DJIA trend reversal. Focus on potential slope divergences in high timeframes.
□ Link (SMI on TradingView): https://www.tradingview.com/script/PQEvcezt-Smart-Money-Index-SMI/
(3) Dumb Money Confidence (Equities)
‘Dumb Money Confidence’ incorporates several indicators showing a record of cycling toextremes. These indicatorscalculate the activity of retail traders and other participants who tend to follow the trend. As the developer states, a more accurate description for the tool would be "trend-following money’ and not “dumb money”.
These are someconclusions when using the‘Dumb Money Confidence’:
When the sentiment is pessimistic and starts to recover, it is time to buy the market
When the sentiment is too optimistic and starts to fall, it is time to sell the market
Explaining why trend-following money is labeled as dumb money
Trend followers tend to wait for several confirmations before entering the market. They are waiting to follow well-established trends. But these trends become well-established just before they become exhausted. In other words, the model assumes that "trend-following" money enters the market near the top and exits near the bottom of major market movements.
Tip:
The ‘Dumb Money Confidence’ can be a useful tool near extreme readings, especially when a highly optimistic or pessimistic reading starts to reverse.
□ Link: https://sentimentrader.com/dumb-money
(4) Monitoring the Fear/Greed Indicators(Equities and Cryptocurrencies)
The ‘Fear & Greed’ indicators are useful tools for understanding the sentiment and the expectations of retail investors, who in most cases lose money.
There aredifferent indicatorsfor different financial asset classes
It is useful to think against what retail traders expect, as most of the time, small investors open the wrong positions in the market
- In the case of a liquidity crisis, don't trade against the retail sentiment
Overbought Area (a sign ofgreed)
A reading near 80 signals the excessive greed of retail traders. In this case, smart money will probably sell the market, with the ultimate goal of buying back at lower prices.
Oversold Area (a sign of fear)
Conversely, a reading near 10 signals the dominance of retail fear. In this case, smart money will probably buy the market, with the ultimate goal of selling at higher prices.
Tip:
Smart money always moves against the expectations of retail traders. Therefore, ‘Fear and Greed’ is an indicator that should be taken seriously when approaching extreme values. However, in the rare case of a ‘black swan event’ or even a simple liquidity crisis, don’t trade against the ‘Fear and Greed Index’.
□ Links:
Crypto Fear and Greed Index (Crypto Fear & Greed Index)
■ Dumb Money vs Smart Money (Key Indicators)
G. P. for TradingCenter.org (c)
October, 26th 2023
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