Image Source: Pixabay
 

The US financial markets and exchanges are regulated and policed by the government to prevent fraud, illegal manipulation, and other unsavory practices and to make sure that they present a fair playing field for all participants, no matter how small.

But there’s plenty of legal market manipulation that occurs all day, every day, by the so-called “smart money” — financial institutions, market makers, fund and portfolio managers, and other large-scale professional traders that manage billions of dollars and make huge trades requiring massive amounts of liquidity, that literally move markets.

To get their liquidity and buy or sell their stocks at the very best prices, the smart money will often cause violent price spikes (in either direction) around obvious support or resistance levels in order to take out the clusters of stop orders they know are gathered slightly below or above these areas — a technique commonly known as stop hunting. Retail traders will either get stopped or get tricked into following the price move, thinking that it is an actual breakout, only to then watch the price violently reverse in the opposite direction. That’s when the retail trader exits the trade with a loss, only to see the price reverse again and continue in the original direction to confirm the breakout.

Here’s a video that explains a bit about how smart money operates at your expense:

Video Length: 00:14:44

This smart money manipulation can play out on intraday as well as longer-term charts. Where there are defined levels containing clusters of stop orders, there will be smart money attempts to hunt those stops and create false breakouts to lure in retail traders.

How do you deal with this smart money manipulation and come out as a winner?
 

Long-Term

If you’re a long-term, buy and hold, investor, you most likely won’t be affected by the smart money monkey business because you’ve ostensibly bought your position based on long-term fundamentals and are not looking at short-term market moves. However, your initial entry could be affected by smart money moves, which could then affect your overall return on investment.

For example, you might get into a long-term Apple position at 150 on what looks like a strong break above resistance, only to see the stock reverse and drop 20 points over the next few weeks. Since you’re a long-term investor you’ll hold onto your position and might eventually end up making a lot of money. But wouldn’t you rather have bought Apple at 130 instead of at 150?

Shorter-term traders swinging position over several months will probably also not get affected, since the smart money spikes will be smoothed out by the market over time unless they have stops placed at the likely hunting ground locations, in which case they will be hunted like any other victim.
 

Intraday

Intraday traders have the most to fear from smart money hunting expeditions since they are often seeking to exploit small fluctuations in price action. This is exactly what the smart money wants them to do because guess who is causing those fluctuations and who is on the other side of the average day trader’s trade.

Day traders will also often use tight stops, to avoid big losses, which then become easy prey for the stop hunters. Midday or lunchtime in NY is usually a low volume-choppy time period during which traders can get their accounts chopped down to size by try to catch upside or downside moves that end up reversing, taking out stops, and then moving back up in the original direction. And rinse and repeat.

So what can day traders do to avoid getting cut to shreds by smart money?

1. Watch the volume of the price action.
   Just because the price crosses a level of support or resistance that you are watching should not indicate a buy or sell signal. A move on light volume can likely be a fake out. Look for a big volume on the move to indicate that the move is real. Or look for a pullback to the original support or resistance level to see if it bounces or continues. Then you can decide whether to take the trade and in which direction.
2. Think like the smart money
   When price spikes just a hair above-established support or resistance levels on light volume, instead of jumping into the trade in the direction of the spike, assume that the smart money is stopped hunting and enter the trade in the opposite direction — along with the smart money.

   I’ll never forget the time I got long a call on one of this price spikes only to watch the price reverse almost immediately. I realized I had just been faked out, and looked at the option price in order to get out and see how badly I was down. I saw the price of my option going up and was confused, until I realized that I had made an error in entering the trade and had bought a put instead of a call. I got out of the trade immediately with a slight gain, because I don’t like being in a trade without a proper plan. My carelessness saved me from a loss and reinforced the lesson of trading with the smart money, not against it.

3. Follow smart money trades
   A wise man once said, “if you can’t beat ’em, join ’em.” This holds very true in the financial markets. If the smart money has way more information and resources to make winning trades than you can ever dream of, the only way to win in the market is to follow them, not try to outsmart them.

   Don’t swim against the current. Stay in the river, become the river; and the river is already going to the sea. This is the great teaching.

   — Rajneesh (famous Indian Guru)

   There are many companies and traders that offer software that scans the markets in real-time for large stock or options trades. I personally use one called BlackBoxStocks which, among other things, scans for large options trades in real-time. The assumption is that options trades totaling hundreds of thousands or millions of dollars are likely institutions or other smart money traders. Depending on the size of the trade and the urgency of the entry (ex. many large trades in a short span of time on or above the asking price), I can decide whether I want to follow the smart money into the exact same position as they have.

   Nothing is a sure thing. The smart money can be wrong or just put on a hedge position or a crazy bet that they don’t mind losing. Trying to follow smart money is only a way to try and increase your probability of success. Isn’t that what trading is all about?
    

Bottom Line

Don’t fight the smart money. They will beat you every time. But if you can figure out how they operate, you can try to follow them into and out of their winning trades instead of simply being their source of liquidity and the prey of their hunted raids.