What the Smart Money does to be Profitable

It is not a mystery that in the financial markets there are two distinct groups, those that make money a large portion of the time (banks and institutions) and, on the other side, those who don’t (the general trading and investing public). These folks tend to struggle to keep up with market returns at best; or end up washing out and losing all their money at worst.

On Wall Street, the cohort that makes money consistently is referred to as the smart money and the aforementioned latter group is referred to as, let’s just say, not so smart money. To be fair, the vast majority of retail traders and investors, through no fault of their own, just don’t know how financial markets really work. They’ve bought into what all the trading books tell them to do, as well as the media and Wall Street. They also fail to recognize that trading, just like any other highly paid profession, is a skill that is learned by not only reading books on the subject, but also through education, active participation and constant reinforcement.

When entering the market, think about who you are competing against.  All of the major firms on Wall Street recruit primarily from Ivy League schools.  This means that they only hire the best and brightest students from the most prestigious schools. After they hire these kids fresh out of college, do you think they just get handed ten million dollars of the firm’s money and are told to go ahead and start trading?  Of course not. They have to pass a battery of tests, followed by a rigorous training process. Some don’t make it, as they don’t have the psychological makeup to be traders. These Wall Street traders have access to unlimited funds and are privy to a lot more information than the rest of us; and get that info in a more timely fashion. By the time we get market information, it’s usually already reflected in the price of that market. This is all legal as these firms have tons of resources at their disposal to uncover this information before anyone else. As you might imagine, the chance of winning against these traders is very low, that is, unless you know how they think, and what they do.

When contrasting what the smart money does versus the rest of the trading population, retail traders are usually focused on only buying stocks or mutual funds while traders on Wall Street are trading both on the long side and the short side. They are also trading and in many different asset classes, such as options, futures and other derivatives. Unlike what most of the public thinks, this is true diversification.

A surprising aspect of how institutions buy and sell the markets is that, like any good merchant, they tend to buy markets when they are down and sell them when they are high, the average investor usually does the opposite. Bad headlines are triggers to sell for most traders, while good news on the economy serves as an invitation to the general public to buy.  The Smart money understands this, as they can spot this behavior every day through the market-making operations.

Institutions have very specific value areas where they will purchase, and on the same token they also have target areas where they will begin paring down or hedging their position.  Yes, they do sell their long positions and cover those open short positions when these areas are achieved. The average retail investor has a difficult time knowing when to take profits because they don’t have a concise strategy that they implement.

Lastly, the number one factor for all institutional trading is risk management.  These folks will always have a cutoff point for every trade. This is usually a hedge or a paring down of a position. No questions asked.  The retail trader often lets his losing trades ride, and cuts off the winning trades very early, which is exactly the opposite of what should be done.

In closing, I want to make sure that readers understand that this is in no way meant to be disparaging of the retail trader.  Instead, it’s meant to get you thinking about what the so called smart money does so that you can be more like them and less like the losing crowd.

Until next time, I hope everyone has a terrific week!

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