A trade can be very “right” in every logical way if your valuation of the underlying asset or your analysis of the chart pattern was done correctly … but if your opinion gets crossways with the larger flow of money in or out of that market, your subsequent losses will feel very “wrong.” Fortunately, there are ways to monitor and predict how big money is being moved around in the markets, which means you can let the flow of investment work in your favor.
For instance, there are a number of assets we can look at now in the middle of 2011 and correctly determine that their prices in late 2008 were undervalued. A November 2008 buy of Exxon Mobil (XOM) at $70 per share would have been “right” in the context of the chart’s eventual correction to $88 in mid-2011. However, the buyer of that asset would have had to hold on to losses all the way down to $55.94 as the recession caused banks, funds, and individual investors to sell off all kinds of liquid assets in their race away from risk. Total interest in S&P 500 futures, for instance, dropped 27% between the market’s 2008 high and its 2009 low.
The Mechanics of Money Flow
Take yourself back to high school economics class: the more demand there is for a product, the more the price for that product rises. Basically, any increase in the total number of buyers in a market, or an improvement in the existing market participants’ willingness to pay for a product, will cause prices to rise. As more money flows into a market, bids will get gradually higher and asks will get gradually higher as more and more participants desire to own a financial asset.
Similarly, the exodus of many individual participants from a market – or just the outflow of a few participants’ capital from a market – will cause prices to drop the same way they do in any physical market when demand for a product decreases. In the case of financial assets (stocks, bonds, etc.), when there are fewer willing buyers, their bids start to inch lower and lower. But more powerfully, when traders become eager sellers, their asking prices plummet. In certain market conditions, like when new bearish information becomes known about an asset, or when macroeconomic risk or losses from other parts of traders’ portfolios makes them want to liquidate entire sections of their portfolios, they become frantic to accept lower and lower market prices … to exit their positions at any cost.
Money Flow in Action
That chain reaction – losses in one market leading traders to liquidate assets in all other markets – was the kind of bearish outflow of money we witnessed in 2008. But the subtle effects of investment money flowing into or out of a market can be seen every day in every market, whether it’s as fully transparent and well-understood or not.
One well understood example is the regular index fund roll in the commodity markets. Index funds, by definition, tend to be long in the nearby futures contracts of various commodity markets. Before that contract month goes off the board, the index funds must sell their March corn futures, for instance, and buy an equivalent amount of May corn futures. Because these funds publicly define this process for their investors, the rest of the market knows about it too and can make them suffer during the roll with aggressively low bids in the nearby contract and aggressively high asks in the next contract.
So you can see why nobody else wants to give away their intentions to the rest of the market so transparently. From individual speculators to hedge funds to sovereign funds to institutions with well-capitalized proprietary trading desks, there is a lot of money out there doing a lot of things that it doesn’t want anybody else to know about.
Using It to Your Advantage
The same concepts of money flow and influence apply no matter what the size of the market … or what the size of the trader. A one-percent change in demand for Wal-Mart stock (WMT) is the same as a one-percent change in demand for Uncle Bob’s grocery store IPO. So even an individual investor trading a $10,000 portfolio can have an outsized influence on a market’s price if he’s not conscious of how his behavior affects a thin market.
The money flow phenomenon can either work to your detriment, or to your advantage. If you actually want move a market with aggressive trading techniques, look for markets with a low volume of overall trading. If you want to be stealthy and let the actions of larger investors do the heavy lifting for you, pick the deeper markets and carefully watch how the big guns are moving their money in and out.
Smart traders typically won’t say what they’ve been buying or how much they’ve been buying. And don’t look to the exchanges or the government to make everyone else’s stock trades public, either. But there is an official government report you can use to keep track of fund activity. It doesn’t come from the Securities and Exchange Commission (the SEC), however. It comes from the U.S. Commodity Futures Trading Commission (the CFTC).
The CFTC releases a weekly report of how much buying and selling has been going on in the markets they regulate, called the Commitments of Traders report: http://www.cftc.gov/marketreports/commitmentsoftraders/index.htm Obviously, you can get great information about the flow of money in and out of commodity markets like oil and cotton from these reports. But even stock traders and forex traders should embrace these reports, too.
In their weekly Traders in Financial Futures reports, the CFTC details how much net selling has been going on in various currency futures and even stock index futures, which can give you an excellent read on how the funds are approaching the overall market. If they’ve been adding to their long positions and trimming their short positions, they’re bullish and an individual investor who’s buying individual stocks will have the wind in his sails – the influence of bullish fund activity is spurring prices higher. On the other hand, if the report shows funds have been liquidating their long positions or establishing new short positions, a bullish individual investor will find himself crossways with an unstoppable force.
A couple of caveats about the Commitments of Traders report: its biggest drawback is that it’s backward-looking. The weekly reports are released each Friday, but only include data up to Tuesday. So a report released July 8th only includes all the activity that happened in the week leading up to July 5th, and if something has happened to drastically change market sentiment since then, the report can mislead you.
The other thing to watch out for is that these reports tend to be a little hard to read clearly. For instance, you can either choose to analyze the futures-only version of the report, or the version that includes both futures and options data. You must also carefully read and understand what types of traders are being represented. In the Traders in Financial Futures report (not the agriculture or petroleum reports) for instance, the report is broken out according to dealer positions (brokerages), institutional positions (banks), leveraged funds (hedge funds), and the more cryptic “other reportables.” There is a lot of nuance in which kind of trader gets put into which kind of category by the CFTC, and you will never be able to break it down to determine which specific fund made which specific trades, but the report will still give you a good overall sense of broad market sentiment during the previous week.
Between one week’s report and the next, you will have to rely on the daily trading volume data you get from your own charting software, and then use your own intuition to determine whether a net buying day was the result of fresh long positions or short-covering. You’ll also be on your own for guessing who was doing the buying.
Nonetheless, as far as technical analysis goes, volume is volume and open interest is open interest. If you can see the interest in a market start to slump, it can be a signal of bearish activity to come while funds liquidate their positions and the population of buyers grows scarce. This is why it’s important to keep your eye on other market participants’ activity, and let the flow of their money take your own trades in a profitable direction.
By Elaine Kub