Following the Smart Money

Previously, I looked at using the Smart Money / Dumb Money Spread as a signal for trading both long and short.  Annual returns on that trading signal were 2.24% using no leverage.

We had a request come in to take a look at using the Smart Money model as a trading signal. The request was much bigger than the simple strategy below, but I wanted to use the request as a way to work through a couple blog posts on Smart Money and building signals / strategies from the model.

First off, as always, I like to take a look at the annualized threshold returns for the signal before building any strategies. The threshold returns for the Smart Money model shows a very positive skew when readings are above 0.70.

[caption id="attachment_911" align="aligncenter" width="564"] Figure 1: Threshold returns for the Smart Money Model[/caption]

For this strategy, I'm going to use the same approach I've taken previously. This will be a long-only strategy. Trading rules are defined below.

Trading Rules

1. Trading dates are Sept 16 1996 to Oct 21 2016 (entire history of the model)
2. Long only
3. No Margin. Account size is $250K.
4. 1,000 shares of SPY ETF
5. Commission of $10 per trade
6. $0.01 per share slippage
7. Go long when:

   • Smart Money closes above 0.70 (Excessive Optimism)

8. Close when:

   • Smart Money closes below 0.30 (Excessive Pessimism)

9. All orders are entered at the open of the next day’s trading session after a signal is given.

This strategy doesn't provide a large number of trades, but it does provide some very good returns.   Some basic trade statistics are provided below.

[caption id="attachment_913" align="aligncenter" width="392"] Figure 2: Trade statistics for the Smart Money Model[/caption]

[caption id="attachment_915" align="aligncenter" width="281"] Figure 3: Win/Loss statistics for the Smart Money Model[/caption]

This simple strategy delivers some pretty good results with some volatility (see cumulative return volatility compared to benchmark chart below).  Overall, following the smart money delivers excellent results (2.91% annualized without leverage).  Performance charts for this strategy are provided below with in-sample and out-of-sample data (out-of-sample is all dates after Jan 1 2015).  Note: Out-of-sample returns are ~4% compared to the 2.91% returns found in-sample.

[caption id="attachment_917" align="aligncenter" width="600"] Figure 4: Performance Charts for the Smart Money Model[/caption]

Check back next week for another look at using the Smart Money model as a signal.