How to Follow the Smart Money and Profit from the Stock Market

We have often heard of talk about Smart Money and Dumb Money.  We wish more investors were in the Smart Money category. However, what is Smart Money? 

According to Investopedia, the Smart Money is defined as cash invested or wagered by those considered to be experienced, well-informed, “in-the-know”, or all three.

The Smart Money sometime seems very abstract. However, the Smart Money can be one individual person or an institution, such as Warren Buffet, Jon Hilsenrath, Goldman Sachs, etc. These people or institutions have the capacity to move the market dramatically.

Just in case, you are not familiar with Jon Hilsenrath, he is a Wall Street Journal Federal Reserve reporter.  You can read the article, “Meet the Man Responsible For Today’s Huge 230 Point Dow Surge” from the following link to see how he is capable of moving the stock market.

http://www.businessinsider.com/jon-hilsenrath-2012-6

When Warren Buffet calls for buying stocks, usually there will be considerable profit.  Just recently, on 3/5/2013 he sent out emails to shareholders to buy stocks. The S&P closed at 1,539 that day.  On 5/6/2013, he said the market would go a lot higher. Sure enough, the S&P closed at 1,617 on 5/6/2013, and it registered a record intraday high at 1,709 on 8/2/2013.

On 12/5/2012, Goldman Sachs said that gold had reached its peak and the real rate would rise. 

The ETF GLD, which mirrors the gold bullion supply, made record highs in October 2012. On 12/5/2012, Goldman Sachs declared that gold had seen its highest level.  ETF GLD was closed at 163 that day. It went up a little bit before it drifted all the way down until 6/27/2013. The closing price was 115 and the bleeding finally stopped.  This was equivalent to a 29% drop.

Here is another example how to follow the Smart Money. 

Billionaire George Soros’s family office hedge fund, Soros Fund Management, filed its 13F quarterly report with the Securities and Exchange Commission on 8/14/2013.  According to Marketwatch reporter Barbara Kollmeyer, Solos bought a bunch of puts on the SPDR S&P 500 ETF, which is a bearish bet.

If you follow the Smart Money, you can profit from their trading patterns.

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How to Profit from the Stock Market by Applying Relative Strength Index (RSI)

People usually argue about how to make money in the stock markets.  The most popular answers would be, “buy low to sell high”, or “buy high to sell higher”.  Nonetheless, the financial market could rise from high to higher, or plunge from low to lower. It is difficult for investors to detect the highest levels or lowest levels.  Thus, investors might lose trading opportunities, or leave too much profit on the table. The Relative Strength Index (RSI) is helpful for traders and investors under this circumstance.

The general conditions of the stock market can be categorized into two classes as trending and range-bound market, which can be determined by stock market movement. In a range-bound market, the general market or stocks waver between the major resistance and support, without breaking out of the existing channel. A trending market usually has apparent trends, either uptrend or downtrend.

When the stock market goes up, the RSI rises accordingly. No matter how strong the market is, and how long the RSI stays in the overbought status, the market eventually takes a breath, and experiences profit taking. Then, the RSI swings or approaches to an oversold territory.

If investors always buy at oversold and sell at overbought, they will certainly make money in an uptrend or range-bound market.  On the other hand, if they sell or short at overbought, and buy at oversold conditions, they will be a winner in a downtrend stock market. The key is to determine market trend.

In general stock market, five primary factors may impact the stock market movement.  They are corporate earnings, Federal Reserve influence, the world situation, investor sentiment and confidence, and supply of liquidity.

We do not want to give you the wrong idea. The market does not necessarily go down once it has entered the overbought status.  In a bull market, the RSI tends to stay in a range between 50 and 80.  Depending on how strong and robust the market is, the RSI can stay in overbought status for many days.  From 5/3 to 5/21/2013, the RSI (5) stayed in range 73 to 85 for 13 consecutive trading days. Until the FOMC minutes showed that some of the Fed members were willing to curtail the asset purchases as early as June this year, the market took a breather on 5/22/2013. 

When the RSI falls to 30 or below, the market or a stock is defined as oversold, and the price of shares might be deemed to rebound in the near term.  When the market was turbulent, for example, during the financial crisis 2007-08, the RSI usually stayed between 20 and 50.  From 2/10/2009 through 3/9/2009, exactly a 1 month period, the RSI ranged from 9 to 43. Most days, during that time period, the RSI stayed in oversold territory.  Until 3/10/2009, the Dow Jones Industrial Average gained 379 points. The market direction was reversed, and the Dow Jones Industrial Average rose from the multiple years’ low of 6,456.  

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How to Interpret Volatility Index (VIX)

The Chicago Board Options Exchange (CBOE) is the busiest and largest options exchange and creator of listed options in the United States.  In 1993, the CBOE introduced the technical indicator Volatility Index (VIX). 

VIX stands for Volatility Index.  It was originally invented to gauge the near-term (30 days) volatility tracked by the S&P 100 stock index option prices.  Technically, the volatility index gauges the implied volatility for a pool of put and call options associated with a particular index or ETF, which includes Indices (the S&P 500, the Dow Jones Industrial Average, and the NASDAQ Composite), and ETFs such as Gold SPDR, the USO Oil Fund, and the Euro currency Trust, etc.  In 2003, CBOE teamed up with Goldman Sachs and modified the VIX using a new methodology. 

The VIX is measured in percentage points and is annualized.  The VIX is based on a new methodology which facilitates investors and traders with the weighted 30-day standard deviation of annual movement in the S&P 500. 

A reading of a certain percent (such as 30%) means there will be a 30% volatility in the market within the next 12 months. This annualized number can be transformed into a monthly number by dividing it by the square root of 12, and daily number by dividing it by the square root of 252, which is the total number of trading days in a year. Top 5 Technical Indicators for ETF Trading discloses how to translate the VIX percentage into expected daily or monthly volatility.

Please note that the expected volatility refers to implied market fluctuation. It is not associated with return.  If the VIX changes in a positive way, the market is expected to increase volatility, and fluctuate more. Likewise, if the VIX is reduced, a less volatile and more stable market should be anticipated within the next 30 days.  One more thing, the 30 days are natural days instead of just trading days.

On 4/15/2013, the S&P 500 dropped 36 points, with a level not seen since last November.  Quite a few unexpected events occurred on that day. There was the Boston Marathon explosion, China missed its GDP expectation, home builder sentiment fell for the 3rd month, and gold futures dropped 10% as well.  The VIX skyrocketed 43%. This level is not often seen in a bull market.  The percentage surge in the VIX at 43%, according to the interpretation of VIX, is equivalent to about 12% of expected monthly volatility, and 2.7% of expected daily volatility in the next 30 days. 

Read more here.

What factors affect gold price

Many factors may impact on gold price. Gold may not move in the same direction with the general market. To make your trade more successful, you can trade ETFs which minor the general market, or do more research on gold.

Investors need some extended knowledge on and special attention to the specific sector ETFs, such as gold ETFs.  Investors need to comprehend the correlation between gold and bond markets, functions in the gold standard, safe havens when war or disaster occurs, its usage in industry, gold price correlated with QE, etc.  

For example, on 8/27/2013, the stock market slumped on the news that the West might strike Syria. However, gold futures gained 1.6% and continued to work as safe havens during world chaos or traumatic current events.  This geopolitical uncertainty pushed gold to a 15-week high. On the other hand, on 9/10/2013, Syria might hand over the chemical weapons, the fear and worries of war diminished, gold price dropped significantly.

Gold price sometimes does not move in the same direction with the general market. ETF GLD mirrors the price of gold bullion.  GLD dropped from a high in October 2012. However, the general market got big boosts since then.  There was more than a 40% spread between GLD and the S&P during October 2012 and June 2013.  The gold price recovered a little bit after the Fed affirmed that there was no pre-set date to taper bond purchasing. Instead, the economic condition, especially unemployment rate, will be closely watched and an intelligent decision will be made based on it.

          If investors would like to trade some ETFs in certain sectors or categories, but the expertise which is needed is beyond their reach, ETFs that track or mirror the general stock market might be better choice. If you really need to trade on gold, you might want to follow the advice from the Smart Money.

For example, on 12/5/2012, Goldman Sachs said that gold had reached its peak and the real rate would rise. 

The ETF GLD, made record highs in October 2012. On 12/5/2012, Goldman Sachs declared that gold had seen its highest level.  ETF GLD was closed at 163 that day. It went up a little bit before it drifted all the way down until 6/27/2013. The closing price was 115 and the bleeding finally stopped.  This was equivalent to a 29% drop.

In 2013, gold had negative return. It was mainly due to expectation of economic stimulus reduction.

Read more here.

Technically speaking, investors buy call options to anticipate the rise of underlying stocks or indices. Likewise, investors buy put options to gain profit when the price drops.  Basically, the ISEE reading just tells us the bullish bets against bearish bets.  Thus, the interpretation of the ISEE index is pretty straightforward. 

 

When the ISEE reaches around 100 which is trend line, the sentiment is treated as neutral status.  When the ISEE is above 100, for example 150, it means for every 100 units of put option orders are there are placed, and 150 units of call option orders are placed during the same time frame.  This case shows that investors are optimistic about the market.  The higher the ISEE reading, the more bullish the market sentiment is deemed to be. Conversely, measures below 100 signal pessimistic views from the retail investors.

The following chart shows that the ISEE drifted down from March 2013 and swung around the flat line 100. Even this chart shows a lot of noise, but you can still see that if the market reached a high, the ISEE tended to capture the pace. Likewise, when the market pulled back, the ISEE revealed this pattern as well.  There appeared a few spikes once a while.

 

S&P 500 vs. ISEE from 1/2/2013 to 6/14/2013.

           The following chart displays the ISEE data from 12/5/2013 to 1/3/2014.  It shows ISEE spiked a few days and well above moving average. It even touched 200 mark. It demonstrated the optimism of the retail investors in past month.

 

How to Profit from the Stock Market by Applying ISE Sentiment Index

The International Securities Exchange launched the ISE Sentiment Index (ISEE) in 2002.  This index is to gauge retail investors’ sentiment in the market by measuring the number of opening call options vs. opening put options, which are placed orders on the International Stock Exchange platform. 

The ISE Sentiment Index is calculated as the ratio of call option volume to put option volume, and is normalized by multiplying 100.  Here is the formula

ISEE=Opening Calls /Opening Puts x 100

When the ISEE reaches around 100 which is trend line, the sentiment is treated as neutral status.  When the ISEE is above 100, for example 150, it means for every 100 units of put option orders are there are placed, and 150 units of call option orders are placed during the same time frame.  This case shows that investors are optimistic about the market.  The higher the ISEE reading, the more bullish the market sentiment is deemed to be. Conversely, measures below 100 signal pessimistic views from the retail investors.

The leading publications often referred ISEE as a helpful trading means due to its inventive arithmetic technique.  It enables investors and traders, even investment professionals, to examine with this exclusive call/put ratio, how retail investors view the general stock market.  Therefore investors can make trading decisions based on the sentiment derived from ISEE.

Some studies show that a gathering of consecutive highs or lows in ISEE reading indicates that the market might move in the opposite direction of what the retail investors are betting on. This characteristic identifies the ISEE as a contrarian indicator. 

As a contrary indicator, we are looking for rising prices when ISEE reading is low-hanging, and retail investors show pessimism about the stocks or market.  Conversely, when the ISEE index poises at a high level, the market prices are going to drop. 

We are not saying the retail investors are always wrong about the market. However, the majority of “dumb money” retail investors who are known as “the herd” are often times mistaken about the major turning points. 

This phenomenon is related to herd mentality and herd behavior.  More and more experts and economists study Behavioral Finance to identify and predict the rational and irrational behavior of investors. One way or the other, we can identify this phenomenon by observing when sentiment extremes occur among retail investors. Historically, extremely high or low ISEE values have been quite bullish or bearish omens. 

Most often, when everyone is very bullish and wants to buy stocks, most investors have already been in the stock market.  The buyers exhaust or extinguish their purchasing power.  The demand has been met and it becomes remarkably difficult for stock prices to continue to gain as investors expect.  This case may spark a sudden sell-off. Meanwhile, the stop-loss orders might trigger and accelerate the downward process. 

The opposite situation might present after dismay sell-off.  If everyone jumps out of the window and disposes shares about the same time period, then the market becomes gradually stable.  The market or stock price starts to advance when the bargain hunters purchase shares. The surge in price is going to prompt a short-covering rally. Moreover, regretful investors buy back shares which they disposed, and fuel the rally even more vigorously!  As a matter of fact, when bountiful investors stretch out to bet on the downside of the market, eventually the stock price might be close to oversold and poised for a nice rebound. 

The logic behind the ISEE index is that inordinate orders placed for either calls or puts underlines the ultimate levels of optimistic or pessimistic judgment.  Generally speaking, the overwhelming bullishness usually foretells an overcrowded market condition.  The market becomes vulnerable (weak) and even dangerous!

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How to Obtain ISE Sentiment Index Data

ISE Sentiment Index is to gauge retail investors’ sentiment in the market by measuring the number of opening call options vs. opening put options, which are placed orders on the International Stock Exchange platform. 

The International Securities Exchange launched the ISEE in 2002.  This index is to gauge retail investors’ sentiment in the market by measuring the number of opening call options vs. opening put options, which are placed orders on the International Stock Exchange platform. 

According to Barron’s, the ISEE data focuses only on calls and puts transaction amounts made by retail investors, such as individual investors, money managers, and hedge funds managers, etc.  Therefore, retail investors’ transaction patterns and behavior is believed to be able to determine the market sentiment from an expert’s view. This is due to the fact that the data is not significantly skewed by a large quantity of options traders or money makers.      

The intra-day ISEE reading is refreshed every 20 minutes.  It is available 10, 30, and 50 minutes after the hour, starting from 7:50am and ending at 4:10pm. However, the moving averages (10, 20 and 50 days) are retrieved once a day only, and available after the market closes. The last reading at close is the daily reading.  Investors can trace the following link to get the most recent data to track the trading pattern and sentiment derived from the options speculators. 

http://www.ise.com/market-data/isee-index/

The International Securities Exchange (ISE) provides free daily data of the ISEE, which are gauged on 1,700 plus securities that trade options on ISE.  The historical data for the ISEE is available on ISE website as well. The ISEE Index for All Securities was accessible starting in April 2002. On the other hand, the other two ISEE indices Equities only and Indices, & ETFs only, tracked back to January, 2006.  Traders can subscribe to the following website to receive the end-of-day email by applying Crtl + Click this link: sign up for the ISEE Alert email. 

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