How to Profit from the Stock Market by Using the Smart Money Flow Index (SMFI)

What is the Smart Money?

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.

Source from: gicharts.blogspot.com

How the Smart Money and Dumb Money trade the stock market differently?

Source: Dr. Jean-Paul Rodrigue Dept. of Global Studies & Geography Hostra University.

Modified by blogger.

We believe many of you have seen the above chart before.  People often confuse the Smart Money, with big money (institutional investors), but actually they are quite different. Usually the Smart Money sorts things out, before everyone else becomes bewildered. The Smart Money possesses ample resources and tools, has considerable expertise, is experienced, and especially has the capability to deal with a crisis. The Smart Money is given an edge over other investors, and has already taken advantage of the discounted prices before everyone else takes action.

After a while, the big investors realize the market environment has been improved. The sentiment turns around, and big money awakens and enters the awareness status. They take action accordingly then. 

When the market enters the mania phase, the public (which we believe is so-called Dumb Money) are afraid of missing the last boat, and hurry to jump into the market. The share might appreciate some, but not much, compared with when the Smart Money or big money did the bottom fishing at very favorable prices.

The Dumb Money is not willing to take a medium-level profit. Instead, they wish the market to go down. Then, they have the opportunity to buy more shares. At this time, the market might already have turned, and the Dumb Money has caught the falling knife.  Then people lose money and complain about being an ordinary investor who does not have inside information, or just isn’t lucky.  This is the typical mentality of the retail investors.

Before we enter the stock market as an individual investor, we need to understand that stock market trading is an unfair game.  The Smart Money knows what Dumb Money is doing, takes advantage of it, and makes money because of this knowledge. However, the Dumb Money is unaware of Smart Money’s moves. If you do not rescue yourself, it will make this game even more unfair. 

We often say 97% of individual investors lose money in the stock market. We are not sure if this figure is accurate, but we believe the majority of market participants (especially the uninformed throng who do not do the required studying) fall into this unfortunate category. Diligent examination, and studying market history and trends must replace “hot news”, following “tips” of others, or just relying on simple luck.

How the Smart Money Flow Index (SMFI) was created?

WallStreetCourier.com created the Smart Money Flow Index (SMFI) in 1997.  This index is derived from the Dow Jones Industrial Average movement in the first 30 minutes after the market opens at 9:30 AM EST and the last hour before the market closes 4:00 PM EST.  The formula is not disclosed.  The SMFI is based on the contracting behavior of the Smart Money and the Dumb Money. 

Basically, the greed and fear of the crowd, or the Dumb Money, controls the first 30 minutes of trading. The news or current events decide the market opening at flat level, gap up or gap down.  On the other hand, the Smart Money usually stays on hold to take action only at the last hour. 

We usually say that small guys open the stock market, and the big boys close the stock market.  Normally, the last market movement in the last 30 minutes is watched closely, and often decides the market trend for the next day or next few days, unless unexpected events or news occurs.

SMFI successfully captured the financial crisis by showing bearish sentiment

Source: http://wallstreetcourier.com/port/po-smart-money-flow-index-001.htm

To determine a bullish or bearish signal revealed from SMFI, you must observe if the SMFI confirms the Dow Jones Industrial Average movement.  When the Dow Jones index declines, but SMFI does not follow this path, it shows the bullish sentiment from Smart Money. Likewise, the Smart Money holds a bearish sentiment when the Dow Jones index rises, but the SMFI is stagnating.

The bear market comes every few years, but it is still difficult for ordinary investors to foreshadow the disaster until it actually happens. That is the reason we are always in shock about bear markets.

However, the Smart Money did perceive a few threatening signs a few weeks before the market large-scale catastrophe in 2007. The above chart illustrates that even though the market was in a topping process, and kept making new highs before it crashed in October 2007, the SMFI did not break any records. This means that the Smart Money did not participate in the rally. Instead, they took a cautious stance and sold at rally.

SMFI successfully seized the market bottom in 2009 by showing bullish sentiment

Source: http://wallstreetcourier.com/port/po-smart-money-flow-index-001.htm

Usually the average length of a bear market is much shorter than a bull market, but average investors still can’t precisely predict the bottom.  During the downtrend market, investors kept trying to become bottom fish, hoping every piece of good news, or effort from the government and the Fed could reverse the trend. Only after lengthy, frustrating endeavors, and asset losses did investors come back to the brutal battle field again.  The SMFI showed the bullish sign around the time when market reached bottom in March 2009.  The above chart demonstrates how the SMFI successfully seized the historical bottom.