Hedge Fund Trader X, the basic hedge fund strategy is the hedged pairing of two stocks. Two stocks, usually in the same or related industries are chosen. The stock expected to rise is bought. This is the long position. The other stock with lesser expectation is shorted, or sold. The hedge fund profits from the relative movement of the two stocks. The effect of being simultaneously long and short the same amount of similar stock is to have no net position. Thus, the hedge fund is not exposed to the general market movement.
Hedge fund Trader X need to maximize profit opportunities, especially intermediate and long term trends. Hedge funds will use maximum leverage or legal borrowing power to improve returns for stocks and bonds. Generally, a hedge fund can leverage stocks by 100 percent. Bonds can be leveraged many more times, often as much as twenty times, depending on credit worthiness. Leverage must be managed carefully, and trading movements opposite the expected move must be cut quickly.
Hedge funds can make money by reducing the cost of leverage or carry. If interest rates are lower in Japan than the United States hedge funds trade U.S. dollars into the Japanese yen. Securities are then leveraged using yen at the cheaper yen borrowing rate. For example, a Treasury bond yielding 7 percent with a yen cost of carry of 2 percent yields 5 percent. Leveraged 10 times the return on the initial investment approaches 50 percent after expenses.
When there is a disparity between two stocks that should be trading at a similar price, traders will employ arbitrage techniques. The expectation is that the two stocks will move closer in price. The expensive stock is shorted while the cheap stock is purchased. The trade is reversed when the trader finds that the relationship is in line once again. Arbitrages often employ the use of the options market as well as stocks in order in manage risk.
Hedge funds are managed intensively. As a result, traders do not employ diversification or risk control (leverage) in a way that an individual or trust department would operate a diversified portfolio. The object of a hedge fund is to hone in on a few investment opportunities that are so well managed that it can provide above-average returns for the investor.
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