As a retail trader, your orders will hardly have any influence on the overall market prices. However, when large investors such as commercial traders or professional traders place their orders, they will likely define where prices are heading. Therefore, it’s of extreme importance to find what these large traders are doing and to be on their side. In this article, we intend to explain how you can spot what the big players are doing, i.e., tracking the “smart money”, and take advantage of their actions.
What is the “Smart Money”?
So, what exactly is the “Smart money”? It’s the name we use to describe professional and large traders with a big amount of capital. In this category, we may find both institutional investors, investment banks and hedge/mutual funds. Not all funds can be considered professional since some of them lack the expertise or the size to truly impact markets. Besides, small funds usually do not have enough capital to place orders capable of influencing prices.
Besides being the traders with the largest amount of capital, these are also the traders with access to more information and knowledge about the markets. Note that both hedge funds and investment banks have huge teams of researchers continuously analyzing the market. They also spend large sums to have access to the latest news before the rest of the market. As such, the odds are that professional traders will spot some opportunities faster than the “average trader”. This is why it’s extremely important to know what they are doing. Due to the size of the organized actions of these traders, they are usually behind biggest price movements. Therefore, knowing what they are doing should be one of the first objectives of any trader.
Tracking the Smart Money
The most direct and efficient method to understand when these players act in simply by looking at a price-volume chart. Due to the large size of their orders, these traders are not able to hide their actions. There is a myth that says that because of dark pools, they are able to hide their actions. Some institutional traders do use dark pools, but they can only hide their orders during execution, which can be a matter of milliseconds. After the order is executed, there’s no way to hide it, as exchanges (and consequently Forex liquidity providers) will report it in the volume.
1- Interpret the direction of their trading
You’ll need to look at prices and volumes to know this. Our article about volume trading explains some ways to observe this. The important thing here is to see where there is a general and organized action, and various funds are buying or selling a currency consistently. You can see this in lower timeframes, like 1 minute, as well as in daily/weekly timeframes.
There are many supply/demand patterns, which our VSA indicator shows, and one of the most prominent SUPPLY ones is a wide range bar, closing on the lows, with volume above the average. The demand ones close on the highs instead. Even though these are wide range bars, many times the prices will continue trending, as you can see in the chart below.
2- Take a look at fundamentals
In long-term trading (daily timeframe and above), good fundamentals make it more likely for big traders to have an interest in a given currency. Traders should be aware when talking about “fundamentals” given that some economic measures like the GDP growth or the interest rate hikes, although important, are not a leading indicator. We frequently see these variables changing only after price corrections in the value of the currency. Traders are better off by looking to the increase of the spread of the interest rates or the movement of a related commodity. These variables are usually a good proxy for the fundamentals that drive currencies and often are leading indicators. In the image below, for instance, we can see how correlated are the AUD with the price of Gold. If the price of gold increases, large traders know that this will benefit the AUD and start buying the currency.
- Sentiment indicators such as COT report and SSI index will give you secondary information. Although it has its usefulness, COT report shows the actions of ALL large traders, even the ones that aren’t so good. Traders should, therefore, pay special attention to their analysis, because the report may have some lag in what comes to be a market turn. Traders should use the COT report mainly as a confirmation, or as a search mechanism for extreme values between large investors and hedgers. The image below presents some examples when the large spread was linked with a market turn
- On the other hand, the SSI shows the actions of small retail traders, which are usually wrong and in the opposite direction of smart money. In this indicator, look for historically high % of long positions to look for a short, and vice-versa for long positions. You can combine both information to be more confident about the right direction you should trade.
If you aren’t using volumes in your analysis, you are missing a big part of the picture. By showing the market’s activity, volume together with prices shows what the big traders are doing. Only these traders are capable of placing orders large enough, and in an organized manner, to sustain market trends, so you should look closely at what they are doing. By tracking the smart money, you can follow their actions and be on the right side of the price movement.
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To do sentiment analysis in Forex, the Speculative Sentiment Index (SSI) is a tool that can be used to understand how different traders are positioning themselves in the market. Continuing with the articles already published on the role that the Commitment of Traders (COT) Report plays in the market, on the analysis of Market Profile and the assessment made of the Money Flow Index, this text will address the interesting topic of sentiment analysis, with a focus in Forex. It will do so mainly by understanding what it is and how traders can read it.
What is the Sentiment?
Sentiment is about spotting traders’ positions, to ultimately understand how they are thinking, and how to take advantage of it. The most used indicator that can be used to understand where retail traders are positioned in the market is SSI. It comes in different forms and formats, but the main idea that traders need to understand when they are using it is that its main purpose is to capture potential opportunities for contrarian trading. And this is so because it allows us to identify where the herd is.
The herd is a pejorative term normally used to describe retail traders. As was explained in our previous analysis of the COT Report, there are mainly three types of players in the market: hedgers, big institutions and small institutions and retail traders. As was also explained, by understanding where retail traders have their positions, new opportunities for contrarian trading open themselves.
Supporting the SSI is, therefore, the way that the markets function from a psychological standpoint. Small and inexperienced retail traders tend to be driven much more intensely by greed and fear. They let their emotions get in the way much more often when compared to professional traders.
The reasoning behind the way these traders operate is very simple, therefore. When the market is clearly on the way up they buy. When the market is clearly on the way down they sell. Greed gets in the way of their reasoning.
The SSI allows us to understand where these traders are – and as more experienced traders to benefit from this knowledge.
How to Use the SSI for Sentiment Analysis?
SSI is the prime indicator to do sentiment analysis (although there are others such as the COT report, for long-term trading), but acquiring the SSI in the form of an indicator, for Forex, does not come cheap. Unfortunately we cannot have access to it via MT4 and so traders can’t always see whether they apply to their trading style unless they actually sign up for one of these platforms that provide this service.
One such broker is FXCM and in this last section we will use their indicator as the starting point to explain how to read the SSI. The indicator can easily be accessed on this website:
It shows the positions of retail traders in different financial instruments. From the difference between the number of traders holding long positions and those holding short positions, it establishes a percentage. When this number is above 0 it means that retail buyers with long positions prevail over the same type of traders with short positions. The same happens in reverse – when below 0 short retail traders are prominent.
So what can be extracted from this particular conclusion: when disparities between these two positions are higher, traders should be on alert for a potential reversal in the market.
How useful is this information? Well, we need to be aware that as with any other indicator the SSI is not the holy grail for trading. Here at ANALYTICAL TRADER, we consider it a relevant indicator but certainly not the most relevant one.
Nonetheless, the SSI is one of the most relevant indicators to understand where retail traders are in the market. And just because of this it certainly deserves our attention.
Continuing with the analysis that sentiment and volume play in the financial markets, in this article we saw how to do sentiment analysis using SSI. This indicator provides a very efficient way to understand where the herd is. When values are above 0 it means that there are more retail buyers in that particular position, and vice versa. In another article we will suggest different ways to trade using the SSI.
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