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FRED GOODMAN'S KEY INDICATORS FOR
INVESTMENT SUCCESS
The Smart Money Indicator is calculated by subtracting the net change in the Dow Jones Industrial Average in the first thirty minutes of trading from the net change during the final hour. The Smart Money Indicator is based on the idea that amateur investors trade near the market's opening — perhaps even entering market orders in the evening for execution the next morning — while the pros wait till the last minute of the trading day to make their trades with as much information as possible. There are many reasons to expect this, and several technicians over the years have observed it. One obvious reason is the fact that amateurs in the market generally have a full time job in another area that keeps them from trading during the day. Other theories include the idea that large institutional orders are filled late in the day after many smaller trades are done early to "test the waters." Some trades are even made in the opposite direction to throw off the opposition! For example, let's assume that there is a large block for sale and, to conceal this fact, the seller actually buys small amounts during the early part of the day to drum up interest in the stock he wants to sell later. Another reason for early trades to be opposite from those late in the day is the presence of international trading. Foreign markets are open earlier than ours, so our opening trading often includes theirs. Since a lot of trading is influenced by the direction of the dollar on currency markets, it is not surprising to discover that it may be in the opposite direction from domestic trading. Whatever reasons are behind it, the phenomenon has been observed for years, and it has value in technical market analysis. The Volume Enhanced Smart Money Indicator takes this idea one step further, by incorporating the volume traded in the opening and closing periods of the trading day. I'll talk more about the calculation in a moment, but first let's see how it has worked. The Volume-Enhanced SMI's finest hour was just after the market reopened following the terrorist attacks of September 11, 2001. In that first terrifying week of market insanity, the Volume-Enhanced SMI consistently logged big upside gains. It was a clue that amid the panic, it was the amateurs who were selling and the pros who were buying. And the pros were right -- after a week of panic, the market took off for almost three months of splendid upside action. The Volume-Enhanced SMI also perfectly called the top of that market move. It began to turn down in late December, perfectly signaling that the run was over. It was less perfect calling the bottom last summer. It turned up aggressively in the panic bottom of last July, but failed to signal that there would be another low three months later -- a slightly lower low on the S&P as it turned out -- in October. This chart shows all of the Volume-Enhanced SMI's signals since December 1997.
The Volume-Enhanced version of the SMI is calculated by multiplying the opening half hour's net change in the Dow by the first half hour of volume, and by multiplying the final hour's net change in the Dow by the final hour's volume. By doing this we are able to amplify the movements of the Smart Money Indicator. The chart below plots the volume-enhanced version against the usual version. It shows the price of the Dow, the regular Smart Money Indicator (just the same as in the chart above), and the Volume Enhanced SMI in maroon. Down at the bottom of the chart I have separated the change in the Dow in the first half-hour (pink line) and in the final hour (light blue). We'll talk about those two lines later, but first let's concentrate on the maroon line -- the Volume-Enhanced SMI. Notice the arrows marked "1" and "2" below. Each points to am outstanding rise in the Volume-Enhanced SMI. Note further that each such rise coincided with the major bottoms made in September 2001 and July 2002. I have marked "3" with a question mark, because I don't know yet if it will continue to move up as sharply as it did at points 1 and 2, but it is off to a great start.
The fact that the volume magnifies the moves of the Smart Money Indicator is ample evidence that the volume, at critical junctures in the market, increases with the amateurs in the early hours and with the professionals in the late trading hours. Furthermore, this phenomenon has occurred even when the total daily volume does not mirror the increases in volume during these two critical periods of the day. It impresses me that, during this period when this Volume Enhanced SMI was producing these valuable insights, the overall volume of the markets was low. However, it is obvious that the smart money was trading in size. Finally, the two bottom lines in the chart above separate the opening price change from the closing hour price change. The Smart Money Indicator goes up or down based on the subtraction of the early from the late change, and it can go up when the market closes down in the afternoon as long as it went down more sharply at the opening. Now of course a rising indicator due to a fall in the Dow is not as bullish as if there were a decline in the morning and a rally in the afternoon -- but the normal Smart Money Indicator will not differentiate. However, it is clear looking at the afternoon price change by itself, that when it is rising, the market is stronger than when it is declining. For example, compare the period starting on September 3, 2002 to the period starting in October 2002. In both periods the indicator was rising, but the market was declining sharply back in September and was rallying in October. Fred Goodman, CFP, is a fee-only Certified Financial Planner based in Los Angeles. You can send him your questions and comments via email at Fred@MarketMonograph.com. The charts and commentary represent what Fred is thinking about the market and thinking of doing for his own account and for accounts he manages. There is no guarantee that you will profit from trading as discussed herein. You may lose money and Fred assumes no responsibility for what you do or do not do with this information. |
