The most popular Hedge Fund strategies and tools used on Wall Street by hedge fund managers like Ray Dalio will be revealed throughout this article. We’re going to give you a short and basic overview of hedge funds, including their history, some of their key features, some examples of hedging strategies and their role in the financial markets.
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According to the latest statistic the assets under management of global hedge funds amounted to 2.91 trillion US dollars in 2018. While the world’s largest hedge fund firm BlackRock has a total of $4.6 trillion assets under management.
Are hedge funds and bank traders really smarter than the rest of us? They certainly receive a higher paycheck than the average Joe. It’s well known that hedge funds tend to attract the smartest people in the world. They all have PhD degrees and access to the most sophisticated hedge fund strategies and tools, but in trading the person with the highest IQ doesn’t always win.
Take for example the notorious Long-Term Capital Management Fund (LTCM) which ended up collapsing despite being led by Nobel Prize-winning economists, PhD mathematicians and scientists.
This is encouraging for the retail trader because it means that we can replicate the hedging strategies and trade like a billionaire hedge fund manager.
Learn About Hedge Funds
Before learning about what is a hedge fund, let's first go through a little bit of history.
The birth of the hedge fund can be attributed to Albert Winslow Jones, who in 1949 took a long position of undervalued instruments and short position in overvalued instruments as an insurance against a downturn in the market, thus creating a Hedge Fund, as he was hedging his position.
However, according to the most successful investor of all times Warren Buffet, the roots of the hedge trading strategy date back to mid-1920. Benjamin Graham, who is widely known as the father of value investing used the same hedge trading strategy in his investment approach.
The strategy was to generate returns irrespective of the market direction; hence the hedge fund takes its name from the strategy itself.
Let’s now reveal the different hedge fund strategies that encompass a broad range of risk tolerance and investment philosophies.
Hedge fund Strategies and Tools
Hedge funds are very diverse in nature and they have the ability and the technical know-how to implement exotic and complex hedging strategies to generate a profit. Depending on the market conditions the hedge fund managers have the skills to formulate new hedge fund strategies.
Nowadays, most hedge funds can be classified in one of these five categories.
List of hedge funds by strategy:
- Short-term flow, aka momentum trading
- Event Driven
- Activist Strategy
- Market Neutral – Mean reversion/arbitrage
- Global Macro Hedge Funds
- Quant and high frequency trading
Please see below a comparison of hedge fund strategies used on Wall Street:
Examples of Hedging Strategies
Event Driven Strategies
The first example of Hedging Strategies is the event driven strategies.
Hedge funds try to capitalize on investment opportunities in the securities which are announcing certain kind of special deals or they are rumored to announce a buyback, or to announce a sale of an asset, dividend announcements.
In the case of central bank announcements they implement their forex hedging strategy.
Another hedge trading strategy is the distressed/restructuring strategy.
The idea behind this strategy is to buy the shares of a company which is nearer to a restructuring deal and there are prospects of higher profits in the near future.
In this case the hedge fund will try to buy enough amounts of shares to account for a significant minority stake or to have enough skin in the game to influence policy decisions. This means that you will have a say in the key important decisions relating to the business.
Momentum or Day Trading Hedging Strategies
The majority of hedge fund strategies focus on the short-term opportunities.
Why do so many hedge fund managers focus on momentum trading?
Well, usually when you’re trading on a short-term basis like when there is a breakout or big news that accelerates a move you’re in the market only for a short period of time. This way hedge funds can eliminate some of the risks associated with holding a trade overnight.
The downside is that you can’t trade big sizes in the market as there is the risk of the market moving against you. However, for the retail trader this can be a tremendous opportunity.
Many instruments tend to gravitate around big round numbers. For example, if GBP/USD exchange rate trades around the big psychological number 1.3000 often times it will lead to quick breakout that can in turn lead to a trading opportunity.
Market Neutral Strategies
The market neutral strategy is the one where the hedge fund uses a combination of complex analysis to identify undervalued or overvalued stocks in the market and take the position in such a way that the overall strategy becomes market risk neutral.
Arbitrage is where they take advantage of price inefficiency in an asset. However, arbitrage strategies are not that common anymore because there are fewer arbitrage opportunities due to the rise of high frequency trading. Nowadays the markets are also more efficient.
Under this category we also have the merger arbitrage strategy.
Typically, these types of hedge funds look for investment opportunities where there is a rumor or high chance of merges or acquisition deals. The merger arbitrage involves simultaneously buying and selling the stocks of the two merging companies.
With this hedge trading strategy, you want to buy the acquire company and sell the acquirer company creating a riskless position.
Global Macro Strategies
Here the hedge fund bets on the global economic trends and geopolitical events. Global macro hedge funds will also get involved in different asset classes (stocks, bonds, currencies, commodities or interest rates). Typically, they will deploy hedging strategies using futures.
With global macro strategy you can survive even in down markets or when the markets crash.
A very well-known example of a global macro strategy was when George Soros crashed the Bank of England in 1992 and sold the British Pound. Sterling fell 15% after the UK withdraws from the ERM and George Soros was able to forecast this event well in advance using his global macro strategy.
Quant and High Frequency Trading
Another bread of hedge funds strategies and tools used on Wall Street is algorithmic trading or high frequency trading. Quant is a short term for quantitative which consist of trading strategies that uses mathematical formula to identify new trends and new trading opportunities.
The most famous quantitative hedge fund is Renaissance Technologies, founded by Jim Simons, who earned $1.6 billion in 2018 topping the list of the highest-earning hedge fund manager in 2018.
Learn more about how high frequency trading works HERE.
Hedge Trading Strategy
One of the most popular types of hedge fund strategies is the turtle trading system developed by hedge fund manager Richard Dennis in 1983. The turtle experiment has proven that anyone can be taught trading successfully. Richard Dennis managed to turn $1,600 into an incredible $200 million in about 10 years.
This hedge fund trading strategy can be used as a foundation for your trading system.
The turtle system is a mechanical trend-following trading system that uses breakouts techniques for entering and exiting a trade.
The entry rule employs a breakout of the 20-day high. So, an entry signal is given when the market breaks to a new 20-day high. The exit strategy was a close below the 20-day low. You have to plan your exit signal the same way as your entry.
Due to the high number of false breakouts this system requires strict risk management rules and a high level of discipline.
Alternatively, if you have a win low rate strategy, you can simply do the opposite of that strategy and turn something negative into something positive.
This is how the Turtle Soup pattern comes to life, which is taking a short position when we break to new 20-day highs instead of buying.
See chart below:
Conclusion – Hedge Trading Strategy
In summary, the ability to go both long and short in an asset is what makes these hedge fund strategies and tools so useful in the day to day operation of a multi-billion hedge fund boutique. In 2018 the top 20 highest-earning hedge fund managers and traders made a cumulative profit of $10.3 billion. To be able to replicate the examples of hedging strategies you need to have the right mindset and discipline to apply the trading rules.
By nature hedge fund managers tend to me secretive, therefore don’t expect them to reveal all their aces in the sleeve. However, you can still master the hedge trading strategy by following the markets, investing and learning continuously from your mistakes and victories.
Thank you for reading! Be sure to check out other guide on the best short term trading strategies.
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