Hedge Funds and Options Trading

Like mutual funds, hedge funds are professionally managed portfolios of various securities. Typically, these funds are marketed to “sophisticated investors” with high net worth, according to the rules imposed by security commissions. With minimum investment requirements usually between $90,000 and $150,000, hedge funds are less regulated and are generally considered more risky than mutual funds. To enhance returns, managers of hedge funds generally take bigger risks, usually in terms of portfolio holdings and strategies that are not permitted in the management of mutual funds.

Usually hedge funds are marketed as being protected from market volatility, or even having the potential to make money in any market environment. A fund that hedges against the U.S. stock market, for instance, profits from a falling market. Hedge funds may also try to protect investors against inflation by investing in precious metals, other commodities, or currencies whose prices are expected to rise faster than inflation.

Hedging strategies range from conservative to aggressive. The conservative type of hedge fund has the preservation of capital as its main goal. This is achieved by holding a combination of investments that offset each other’s risk. These funds might appeal to a client worried about market volatility. Aggressive hedge funds employ leveraging strategies, which magnify the gains or losses of the underlying markets. Although short-selling enables a manager to profit from a market decline, the losses are theoretically unlimited if the market goes up.

Advantages of Hedge Funds

A hedge fund that anticipates market trends correctly can protect a unitholder from declines in stock markets, commodity prices or foreign exchange rates. The concept provides further diversification for client. Aggressive hedge funds, because of the range of instruments and strategies they employ, have the potential for far greater capital gains than conventional equity funds.

Potential Disadvantages of Hedge Funds

Because of the risk of substantial losses and the sometimes intricate strategies that often characterize these funds, they are considered suitable only for affluent, sophisticated investors. Hedge FundsShort selling, for instance, exposes an investor to potential losses greater than the amount invested. Volatility is also a feature of these funds. Affluent individuals are better able to sustain drastic swings in a fund’s performance or even substantial losses.

While hedging can reduce risk, it can also reduce returns. There is no guarantee that a manager will correctly anticipate the direction of the market, the price of a commodity, or the value of a particular currency. If a manager hedges against a decline in the value of a security, and the price of the security rises, the unitholder’s losses will be greater than if the position had not been hedged.

Similarly, hedging strategies to protect the investor against inflation can backfire if the commodity, currency or other security purchased for the fund depreciates in price. Even if the manager correctly anticipates the underlying trend, a particular hedging tactic may not be effective. The correlation of the hedging instrument may not be as negative as anticipated. In some cases, a manager may not be able to hedge against an eventuality that has been widely anticipated in the market.

Another risk is related to the level of trading activity on specific futures or options contracts. Just as the liquidity of the fund itself should be a consideration, there may also be a limited market for a particular security at the time that a hedge fund manager wants to close out a position.

Hedge Funds and Forex Trading

In Forex trading, hedge funds are speculators. Hedge funds are pools of money that are raised from wealthy individuals, pension funds, endowments, corporations, and others and are managed by a fund manager. Traditionally, a hedge fund would try to do just what its name suggests: hedge against risks like currency risk. Nowadays, hedge funds are much less concerned with hedging risk. They prefer taking on risk instead by buying some currencies while selling others – to try to make money.

Hedge funds typically use massive amounts of leverage when they trade in Forex market. This means that they borrow money from someone with whom they have a credit agreement (a bank or other large financial institution), then turn around and use that borrowed money to buy and sell currencies.

This system seems to work pretty well when the credit market is functioning well. But when the credit market freezes up and stops functioning, this system of borrowing money to invest in the Forex market can unravel quickly, causing huge price swings in the value of various currencies. This was the case during the financial crisis of 2008.

Heading into 2008, many hedge funds had leveraged up, getting into trades with the Japanese yen. A carry trade a currency trade that is established to take advantage of large interest-rate spreads that may exist between two countries. Essentially, you sell currency with the lower interest rate, and you use the funds to buy the currency with the higher interest rate. By doing so, you will have to pay the lower interest rate for the currency that you sold, but you earn the higher interest rate on the currency that you bought – and you get to keep the difference.

This strategy unraveled for hedge funds in 2008 when the financial crisis caused the credit market to freeze. It happens that the money that hedge funds borrow from banks and other financial institutions to leverage their trades is loaned on a short-term basis – often only overnight. Therefore, when the credit market froze, hedge funds were cut off from their capital supply and were forced to unwind their carry trades because they could no longer meet their requirements – the amount of cash that must be on hand to hold a trade. It didn’t matter if the hedge funds thought the trades were still good trades or not. They didn’t have the money so they couldn’t hold the trades.

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Filed under: Options Trading

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