How to Operate Like a Hedge Fund

by Minority Fortune

Hedge funds seem to be shining in this down economy. Recently, they’ve gotten a lot of attention for their positive returns and gain in assets. If you’re not familiar with hedge funds, they are investment firms that manage large amounts of money with the intent to make large annual gains using complex measures. To be eligible to use hedge funds, an investor has to put up a large sum of money to be able to invest with an institutional hedge fund firm. While the costs may be a barrier to entry, you can still learn their tactics and attempt to apply them.

Learning a thing or two about the strategies implemented by hedge funds and seeing how to use them in our own individual investments wouldn’t hurt. An article on Investopedia provides key insight on the trading strategies implemented by hedge funds. The goal of hedge funds is to limit risk and exploit opportunities for gains.

Investopedia’s Example: Say a firm is interested in a particular retailer. Overall, the sector isn’t doing so well. However, the firm finds out that the retailer owns valuable real estate in the company’s balance sheet. They choose to invest in their stock, buying 1000 shares of its stock at $50. Meanwhile, they find the retail industry’s ETF (index based fund) and short (bet on it losing money) 500 shares at $100.

The firm has bought $5,000 worth of shares supporting this particular retailer on an isolated factor (its real estate in this case). The firm also covers its butt by shorting $5,000 worth of retail industry stock. This way, there’s little possibility of the firm losing its entire $10,000 investment. If the individual retailer stock goes down due to the industry, the hedge fund will earn money from its shorts.

Ideas Extracted from Hedge Funds Operations:

These various securities can be employed in a number of different ways to hedge against:

  • Sector/Market Risk – Isolating one opportunity in a given sector often involves taking an opposing position in the sector’s ETFs or a basket of competing stocks. For example, in the retail situation above, the hedge fund shorted the retail ETF, while being long on the retailer.
  • Sudden Drop Risk – Hedging against upcoming volatile events, such as an uncertain FDA decision, often involves purchasing put options [selling] in the same stock to go alongside a long position [buying] – a cheap insurance policy that gives investors a guaranteed selling price.
  • Sideways Movement Risk – Investors can even hedge against a lack of movement by writing call or put options against their existing stock position, which provides them with a return on investment while the stock is sideways in exchange for a known selling price.

How to Design Hedges
The actual design of a hedging strategy boils down to a simple, three-step process:

1. Identify Suitable Securities
A good hedge often uses the cheapest possible security that offers the protection needed. For example, in the retail situation above, using put options on the retail ETF may be cheaper than purchasing a full short position, while offering the same benefits as the more expensive alternative.

2. Check the Correlation
Correlation is very important to consider, as any variance equates to additional unmitigated risk. For example, using gold as an inflation hedge may be less correlated to inflation than using a TIPS ETF or other similar securities. After all, any movement in gold that’s not tied to inflation could mean additional downside.

3. Determine the Value
A hedge’s total value must always match the value of the underlying position in order to completely isolate an investment idea. Going back to our retail example, the total value of the retail ETF short position matched that of the long position in the retailer in order to completely offset any decline in the retail sector. However, the positions can be adjusted as needed, depending on situation and sentiment.

We think these tactics can give you a brand new perspective on your investment strategies. It’s wise to analyze these hedge fund strategies and ponder how they can help you in your own trading. Discover if there’s any scenarios in your portfolio where these strategies can be used. (i.e. Invested in Apple, but don’t think the overall tech market is doing well. Might consider buying $500 in shares in Apple and short $500 against the tech market.)

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