It’s a good idea for traders to follow the smart money and know how this group of savvy traders is positioned. The “smart money” is any group of traders who consistently beats the market over time. Over the decades, traders have developed various indicators to give them hints as to what the smart money is doing. One of these popular indicators is called the Smart Money Index (SMI), sometimes also referred to as the Smart Money Flow Index. This indicator is updated here, for free.
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What is the Smart Money Index
The Smart Money Index, or Smart Money Flow Index, is based on the belief that the “smart money” trades at the end of the day while the “dumb money” trades at the start of the day. Why?
- “Dumb money” supposedly reacts emotionally to after-market hours news. Reacting and trading emotionally often leads to losses.
- “Smart money” supposedly spends the day evaluating the dumb money’s reaction to news, hence why they trade at the end of the day.
The Smart Money Index encourages traders to follow what the smart money is doing at the end of the day and ignore what the dumb money is doing at the start of the day. It was created by Lynn Elgert in the 1980s and popularized by Don Hays in the 1990s. This indicator became famous in 1999 when it successfully predicted the 2000-2002 bear market and stock market crash.
How to calculate the Smart Money Index
The Smart Money Index’s calculation is very simple. Remember, the Smart Money Flow Indicator compares what the “dumb money” is doing at the start of the day vs. what the “smart money” is doing at the end of the day.
To do this, we must look at the Dow Jones Industrial Average’s intraday price changes:
- Calculate the Dow’s nominal change in the first 30 minutes of each trading day (9:30 a.m. EST – 10 a.m. EST)
- Calculate the Dow’s nominal change in the last hour of each trading day (3 p.m. EST – 4 p.m. EST)
- Today’s Smart Money Index = yesterday’s Smart Money Index – the market’s gain/loss in the first half hour of trading today + the market’s gain/loss in the last hour of trading today.
Here’s an example of how to calculate this indicator.
- In this example, the Smart Money Index was at 10,000 yesterday.
- Today, the Dow increased +25 points in the morning (9:30 am – 10 am) and fell -20 points in the afternoon (3 pm – 4 pm).
- The Smart Money Index’s value today = 10000 – (+25) + (-20) = 9955
As you can see, the Smart Money Index penalizes strong mornings and likes strong afternoons.
This is what the Smart Money Flow Index looks like:
How to use the Smart Money Flow Index
There’s no hard-and-fast rule as to how the Smart Money Index should be used. There’s no black-and-white way to say “Smart Money Index today is flashing a BUY signal for stocks” or “SMI is flashing a SELL signal for stocks”. However, there are general guidelines as to how traders use this indicator.
Use the Smart Money Index to confirm the stock market’s trend
Traders widely believe that if the stock market is trending up and the Smart Money Index is also trending up, that’s a good sign. It means that the “smart money” is supposedly supporting the stock market’s advance.
If the stock market is trending down and the Smart Money Index is also trending down, that suggests that the market will keep trending down because the “smart money” is supposedly selling stocks.
Watch out for divergences between the Smart Money Index and the stock market’s trend
The Smart Money Index is widely used to spot divergences (situations in which the Smart Money Index IS NOT confirming the market’s trend). This can supposedly predict when the market is about to turn and the trend is about to change.
- If the market is trending up but the Smart Money Index is not trending up, traders believe this to be a bearish sign for the stock market because “the smart money has already turned bearish”.
- If the market is trending down but the Smart Money Index is not trending down, traders believe this to be a bullish sign for the stock market because “the smart money has already turned bullish”.
How useful and accurate is the Smart Money Index?
In a nutshell, this indicator is not very useful. History demonstrates that traders who use this indicator are no better off than flipping a coin to decide whether to buy or sell. The only thing “smart” about the Smart Money Index is its name.
For starters, there is very little truth to the belief that “the dumb money trades at the start of the day” and the “smart money trades at the end of the day”. Both dumb money and smart money trade at all hours during the day, without a clear and consistent pattern.
But more importantly, the Smart Money Flow Index has a very mixed track record of predicting market crashes, with plenty of false alarms.
For example, the Smart Money Index fell consistently throughout the 1950s and 1960s. If you sold at any time during these 15 years because “the Smart Money Index is falling”, you would have sold too early:
From 2003-2009, the Smart Money Index consistently trended downwards. While the U.S. stock market did crash in 2007-2009, the bearish sign from the Smart Money Index was 4 years too early. Bearish signals that are too early aren’t very useful because traders who sell too early will miss out on too many gains.
Where can I find the Smart Money Index?
You can see the Smart Money Index updated in real time here, for free.
Other smart money indicators
If the Smart Money Index is not much more useful than flipping a coin, are there other smart money indicators that are actually useful?
Insider Buy/Sell ratio
Insider trading data is incredibly useful. The stocks that corporate insiders buy consistently outperform the market, and the stocks that insiders sell consistently underperform the market. Insiders are the real smart money because:
- They know things that the public doesn’t know.
- Insiders can better act on public information.
The Insider Buy/Sell ratio takes a ratio of the amount of insiders buying stocks and divides it by the amount of insiders selling stocks.
- When the Insider Buy/Sell ratio is high (i.e. many insiders buying stocks), that has been an accurate bullish sign for the stock market.
- When the Insider Buy/Sell ratio is low (i.e. many insiders selling stocks), that has been an accurate bearish sign for the stock market.
The Smart Money Index supposedly allows you to follow what the smart money is doing by focusing on the market’s price action at the end of the day and ignoring the market’s price action at the start of the day. In reality, the Smart Money Index has a very spotty track record in terms of being useful for actual trading.