"Smart Money" Traders Betting Against Sucker Rally

An awful lot of people seem to think the worst is over for stocks. But a big time bomb may be close to detonating in the derivatives market. The "smart money" commercial traders - who are usually correctly positioned at key market junctures - have been massively fading the current stock rally.

Their net position last week in S&P 500 futures and options was 1.92 standard deviations below the moving average I use for my trading setup based on the Commitments of Traders data.

Friday's data saw them get even more net short. Their net position as a percentage of the total open interest fell to 2.28 standard deviations below the average. That's the most bearish they've been since early December - right before the market collapsed and took out its 2002 lows.

But the data isn't entirely bearish and is giving some mixed signals. While the commercials have been running for the exits, the "dumb money" small traders have also gotten bearish. My trading setup needs to see both groups of traders give the same signal before I'll actually bet money on a trade. And the little guy got super-bearish last week, which actually resulted in a bullish signal for the S&P 500.

Then, on Friday, the small traders significantly increased their net long position. They went from 0.53 standard deviations below the average to even with the average on Friday. For my signal to flip to bearish, they need to hit 0.2 standard deviations above the average.

What does all this mean? Until the two signals agree, my setup for the S&P 500 will remain in cash.

This setup also has a three-week trade delay, and the two signals stopped agreeing with each other as of the March 17 COT report. So my setup goes from bearish to cash on the open Monday, April 13, and will remain so for the next three weeks, at least.

As for gold, the other market for which I've developed a COT trading setup, the signal remains in cash next week - its ninth in a row. But there's suddenly some bearish news looming over the horizon, after four weeks of potentially bullish posturing.

On Friday, the "dumb money" large speculators upped their total open interest by a sizable amount, bringing it to 0.69 standard deviations above the average, up from 0.55 standard deviations below the average the previous week. This sudden turn-around has caused my large spec open interest signal to go bearish, after four weeks in the bullish column. This signal works with a seven-week trade delay, so the flip-flopping signals don't have any bearing until the end of April.

What happens then depends on what the other signal that makes up my gold trading setup does. That other signal is based on fading the large spec net position as a percentage of the total open interest. (There is also no trade delay for this second signal - meaning the trade would be executed on the Monday after the signal.)

The large specs also seem to be on the move in their net positioning. Their position has gone from 0.74 standard deviations above the moving average to 1.12 standard deviations above. They haven't quite hit excessive territory yet, but they're getting closer. I guess the gold bugs are working overtime trying to get everyone piling in. So my signal based on fading the large spec net position remains bullish. But for the entire gold setup to go bullish at the end of April the large speculators have to put on the brakes. Or we could be in for continued volatility in bullion.

Hope you had a great weekend, and good luck this week!

TAGS: S&P 500, SPX, gold, COT, Commitments of Traders, derivatives, Black Swans, market timing, trading system development, CFTC, Commodity Futures Trading Commission, COTs Timer, Monte Carlo, out-of-sample testing, walk-around testing