How to beat the hedge funds in your trading

Last Wednesday, I noted that gold had made a top at the $1,390 area. That meant it had well missed the widely-touted target of $1,400. But as I have been explaining, missing a common target that the media have got their teeth into is perfectly normal and it's a tradable event.

So, it's instructive to review the changing extreme sentiment picture in gold. Doing so also throws a spotlight on how very important this factor is in my analysis of any market.

At critical times, getting a handle on sentiment can give valuable clues as to market direction. Even better, it gives small traders an advantage in trading against big hedge funds and that could very likely lead to some profitable trades.

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Don't make this fatal mistake

And if the market goes against your forecast, you are tempted to hang on, expecting the market to see it your way, given enough time. You only read the articles which agree with your ideas, and dismiss those that don't. This is called confirmation bias'.

Of course, within this time, you can suffer dramatic losses if the market fails to see reason!

A much better approach to analysing the markets is simply to discard your firm beliefs and instead monitor what others believe. If enough believe gold is undervalued, the market will rise (and vice versa). After all, the market is a vast voting machine and players with the most money have the biggest vote.

So, to get a handle on what the majority of traders believe, I take a look at sentiment measures, such as the Daily Sentiment Index (DSI) and also the COT (commitments of traders) data.

The most valuable trading weapon

Here, the DSI readings were in the record-low 4%-8% range, as I noted at the time. Also, there were many more spec shorts than longs in the COT data.

This was a clear sign that the market had become oversold and the selling pressure was about exhausted.

At this point, the amateur trader who was short was decidedly very happy with his trades which were in massive profit. This euphoric state would tempt many to add to their positions right at the lows.

But this is precisely the time to look to exit with those profits. Yet, that would mean overriding your natural human tendency.

And that is the secret to great trading being able to recognise euphoria inside yourself, step back, and press the manual override button. This is the most valuable weapon any trader can possess.

How I knew gold wouldn't hit the target

And on Friday, I received further confirmation that sentiment had reached an extreme at last week's high the COT data.

Like they did during the week ending on Tuesday, the non-commercials (hedge funds) made a massive swing to the bullish camp. They now hold four times as many longs as shorts a complete reversal from their holdings only ten weeks ago. They have truly bought into the gold rally story (again).

And this morning, gold is trading $65 below the high. So much for the skills of the hedge funds!

Remember, hedge funds are largely trend-followers and are usually on the wrong side of the market at major turns. Small traders such as us can take advantage of this. In fact, this knowledge can give us our best trades.

Taking money from the hedge funds

The market is under pressure and is challenging last Thursday's low. The $1,350 support has been breached and market is heading for my next support, which is at or near the tramline where it would make a traditional kiss.

But will it reach that level before turning back up? Note that momentum is carving out a potential positive-momentum divergence here. And any reversal would set up a probable reversal, which could be very sharp.

My stance now is to watch the action for signs of a turn back up and it will do so when the bullish froth has been driven from the market. That means hedge funds abandoning their extreme bullish positions and I shall be eagerly watching the forthcoming DSI and COT data.

The bottom line is this: just when almost everyone believes in a particular view, the market reverses and takes their money away. A small trader can make big profits simply by trading against the hedge funds. Now that's a satisfying thought.