What is Smart Money?

Key Highlights

• Smart money represents funds managed by institutional investors, financial entities, and professionals, strategically invested for maximum returns.

• Traders can recognise smart money through indicators like trading volume, stock pricing, and index options.

• Understanding smart money is vital, offering valuable insights into market movements and providing a strategic advantage to retail investors.

How to Identify Smart Money?

To identify smart money, individuals should look for the following signs.

1. Trading Volume

Traditionally, it is believed that well-informed speculators tend to invest more heavily. Consequently, smart money might be linked to abnormally high trading volumes in a stock without any apparent reason to the average investor.

2. Stock Pricing and Index Options

Pricing and indices, primarily influenced by knowledgeable market participants, serve as a crucial source of information. However, this information can be intricate and bewildering for inexperienced investors. As a result, it is utilised by a select group of informed market participants. Understanding the actions of smart money investors and their investment choices can be advantageous for individual investors.

3. Data Sources and Analytical Methods

Data providers employ diverse methods and sources to gather transaction data from both commercial and retail traders. Analysts use these data reports, sourced from platforms like the Commitment of Traders (COT), to differentiate between non-commercial and commercial trading activities.

These data sources reveal the distinctions in how these two groups position themselves in the market. Nevertheless, it is important to recognise that investment activities alone may not fully convey the intentions of these investors.

4. Insider Buying

When insiders, like board members or executives of a company, purchase their company's stock, it is considered a smart move. These individuals typically possess additional, insider information about their organisations. Consequently, their decision to buy shares indicates confidence in the company's future prospects.

Smart Money Index

The smart money index is employed to assess the stock market performance of experienced investors compared to retail investors, known as dumb money. Institutional investors carefully analyse market price movements throughout the trading day, leading to continuous smart money trading. In contrast, dumb money is predominantly traded at the beginning of the trading day, reacting to early morning news, overnight developments, or economic data.

The smart money index serves two primary purposes for traders

Confirmation of Asset Trend

The smart money index doesn't dictate when to trade a specific asset. Instead, it provides insights into what investors can anticipate in the short term. For instance, if an asset is experiencing an upward trend, the smart money index can signal when this trend is about to change.

Analysing Discrepancies between Smart Money Index and Market Trends

Investors continually monitor changes in market trends in relation to the smart money index trends, a practice known as divergence identification. For example, if asset prices drop while the smart money index rises, it often suggests a potential price increase.

How to Trade with Smart Money?

There are primarily three signals that individuals can identify, apart from volume and price action, to trade using this concept.

1 Aggressive Initiation Activity

This signal refers to a significant shift in the price of a financial instrument, caused by either aggressive buyers driving the price up or aggressive sellers forcing it down. This aggressive buying or selling often happens after an asset has been trading within a relatively stable price range without a clear trend. In this scenario, well-informed financial professionals and entities gradually build up their positions. Afterward, they aggressively buy or sell the financial instrument to influence security prices in their preferred direction. When the asset's price begins to move rapidly, they have limited time to establish larger positions. Therefore, they accumulate their positions beforehand to prepare for the upcoming move.

2 Sideways Price Action Area

Regardless of the timeframe they are using, retail investors should pay attention to sideways price action areas. These regions are crucial because knowledgeable institutional investors and financial experts accumulate their positions there. However, it's essential to note that these areas should have low volume to signify the continuation of an existing trend.

3 Resilient Price Rejections

A strong rejection occurs when a security's price aggressively moves in one direction before swiftly reversing and moving in the opposite direction with the same intensity. For instance, if sellers are aggressive and push the asset's price in one direction, buyers suddenly become more forceful and overpower them, leading to a rapid upward movement in the security's price. The area where this strong rejection and countermove transpire becomes crucial, as it forms the resistance or support zone.

The Scale of Smart Money

The smart money index is employed to assess how experienced investors perform in the stock market in comparison to retail investors, often referred to as dumb money. Institutional investors analyse market price movements throughout the trading day, leading to continuous smart money trading. In contrast, dumb money is primarily active at the beginning of the trading day, responding to early morning news, overnight developments, or economic data. Smart money's influence is significant, shaping market trends and impacting the overall financial landscape. It represents the collective wisdom and financial power of experienced investors, making their actions closely observed and often emulated by other market participants.

Conclusion

Smart money is often distinguished by its ability to anticipate market trends, adapting swiftly to changing conditions. Understanding smart money is essential for individual investors as it provides valuable clues about potential market movements. For everyday investors, aligning their strategies with the movements of smart money can enhance their chances of making profitable investment choices. While the stock market can be complex, grasping the concept of smart money simplifies the process, enabling individuals to make more informed and successful investment decisions.