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A Look at Smart Money Flow

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It's showing a negative divergence in the S&P.

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To try to get a handle on where the greatest risk lies in the market, we try to get our minds around who is most likely doing what. Knowing that to the best of our ability, we look at past patterns to see if the group we've isolated has had a good track record at market turns, or a poor one.

To make things easier to understand, often the two groups are nicknamed "smart money" (usually bullish at market lows and bearish near highs) and "dumb money" (the opposite of the smart money). This doesn't reflect on the intellectual abilities of the participants, rather it's shorthand to identify their typical positioning at inflection points.

Today we're taking a look at Smart Money Flow.

What is it?

This indicator could go by any number of different names, and different means of calculation. To the best of my knowledge, the one I'm writing about today was first uncovered by trader and author Larry Williams.

All we're doing is looking at how various stocks and indexes act between the opening of regular trading and the close, and also their performance between the close and the next day's open. The theory is that emotional traders react to news events overnight, and place orders in the heat of the moment or before they head off to their regular jobs. This buildup of orders causes gaps between the close of trading and the next open when these orders are executed.
Professional traders, who have the benefit (?) of watching the market trade all day don't trade at opening prices, rather they take their time and try to execute at the best possible price when liquidity is the highest during regular trading hours.

There has been an absolutely remarkable difference between the two on some indexes. For some that don't gap open very often, or with much magnitude, the signals this indicator gives are rare but often meaningful when they do come around.

Why should we follow it?

This particular indicator is extremely simple to calculate – all you need to know is each day's opening and closing prices. There is no lag in the data, so that is not an issue, and it can be calculated on almost any stock or index.

Historical comparisons are easy and readily available, so we don't waste our time watching for signals that will either never come or don't mean much of anything when they do. For the vehicles that do work well with this, positive and negative divergences show up quite well, and are often very useful heads-ups of potential buying or selling differences between the controlled and emotional money.

What are the challenges in using it?

Some indexes, like the S&P 500 cash index, have "artificial" openings and will not work with this method. We need to find something that gaps up or down from the previous closing prices to reflect order imbalances overnight.

For some stocks or indexes, even those that gap, this methodology just doesn't work very well. For whatever reason, the relationship between opening and closing prices is either not consistent, or just not a good predictor of future activity. It takes some work to find the ones that are amenable to this kind of analysis.

We're of course making some big assumptions about who is the "smart" versus "dumb" money here. Obviously not everyone who places an overnight trade is emotional, so we have to take these descriptors with a grain of salt.

What does it look like?
What's it suggesting now?

We can see in the chart above that last October, when the S&P was floundering around and not making much progress, the Smart Money Flow was making higher lows every time the futures came back down to test the lows. This tells us that the controlled money was being more aggressive.

The Flow rose steadily along with price until mid-December, when we saw a minor divergence. The S&P futures were scoring new highs, but the indicator was not. This will happen when prices gap up in the morning (showing buying demand from the "dumb money") and sell off during the day (as the "smart money" takes advantage of the opening prices).

From that point, we kept seeing the Flow making higher highs, a good sign that traders were interested in buying during regular trading hours. Lately, though, that has changed as the index has been selling off during the day while seeing some opening gaps higher. That has created another negative divergence between price and the indicator, where not only is the indicator not making new highs, it has even gone well below where it was at the March price lows.

These divergences are rare in the S&P – most often the indicator follows along with price almost step-for-step. On other vehicles, like QQQQ, divergences are much more common. In fact, on Monday this Flow hit a new all-time low in QQQQ, and is just a tad off a new all-time low in SMH. Even during a roaring bull market, selling gap up opens in those indexes tend to work in your favor over time.
No positions in stocks mentioned.

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