There are four broad styles of hedge funds and multiple strategies beneath each style which are discussed at length in the book Hedge Funds Demystified by Scott Frush. This article summarises the four broad hedge fund styles and provides an insight into the management of hedge funds.

In many cases, Hedge Fund managers combine strategies from the styles below but regardless of the strategy, each has the aim of generating attractive absolute returns. This is the fundamental difference between most investing funds (eg mutual funds) and hedge funds; hedge funds aim to deliver absolute returns in both a bull and a bear market.

The following are the primary strategies employed by hedge funds (such as the infamous Long Term Capital Management Fund), grouped by style:

Tactical (also known as directional)

1. Macrocentric – Strategy where the hedge fund manager invests in securities that capitalise on domestic and global market opportunities. Trading strategies are generally systematic or discretionary; systematic traders tend to use price and market-specific information (often based on technical trading rules) to make trading decisions, while discretionary managers use a judgmental approach regarding differences between current financial market valuations and what is perceived as the ‘correct’ or fundamental valuation.
2. Managed futures - Strategy where the hedge fund manager invests in commodities derivatives with a momentum focus, hoping to ride the trend to attractive profits.
3. Long/short equity - Strategy where the hedge fund manager combines long holdings of securities that are expected to increase in price with short sales of securities that are expected to decrease in price. Long/short portfolios are directional – that is, the investment strategy is based on the manager’s expectation of future movements in the overall market – and may be net long or net short. Short positions are expected to add to the return of the portfolio, but may also act as a partial hedge against market risk. However, long/short portfolios tend to be quite heavily concentrated and thus the effectiveness of the short positions as a hedge against market risk may be limited.
4. Sector-specific – Strategy where the hedge fund manager invests in markets in specific sectors by going long, short, or both.
5. Emerging markets – Strategy where the hedge fund manager invests in less developed, but emerging markets.
6. Market timing – Strategy where the hedge fund manager either times mutual fund buys and sells or invests in asset classes that are forecast to perform well in the short term.
7. Selling short – Strategy where the hedge fund manager sells short borrowed securities with the aim of buying them back in the future at lower prices thus making a profit.

Relative value (also called arbitrage)

1. Convertible arbitrage - Strategy where the hedge fund manager takes advantage of perceived price inequality with convertible bonds and the associated equity securities.
2. Fixed-income arbitrage - Strategy where the hedge fund manager purchases a fixed-income security and immediately sells short another fixed-income security to minimize market risk and profit from changing price spreads. This was one of the key strategies employed by Long Term Capital Management before its demise. This is known as a non-directional spread trade. Managers take equal long and short positions in two related securities when their prices diverge from their typical relationship. Positive returns are generated when the prices of the two securities re-converge. Because arbitrage opportunities can be limited and the returns from these trades tend to be quite small, arbitrage strategies often employ higher leverage than other funds in an attempt to maximise the profit from exploiting these perceived mis-pricings.
3. Equity-market-neutral - Strategy where the hedge fund manager buys an equity security and sells short a related equity index to offset market risk. An example of this would be buying Coke stock and selling Pepsi short. Market neutral managers attempt to eliminate market risk by constructing portfolios of long and short positions which, when added together, will be largely unaffected by movements in the overall market. Positive returns are generated when the securities which are held long outperform the securities which are held short. Market neutral portfolios tend to be more heavily leveraged than the long/short directional portfolios discussed above.

Event-driven

Event-driven strategies seek to take advantage of opportunities created by significant corporate transactions such as mergers and takeovers. A typical event-driven strategy involves purchasing securities of the target firm and shorting securities of the acquiring firm in an announced or expected takeover. Profits from event-driven strategies depend on the manager’s success in predicting the outcome and timing of the corporate event. Event-driven managers do not rely on market direction for results; however, major market declines, which might cause corporate transactions to be repriced or unfinished, may have a negative impact on the strategy.

1. Distressed securities - Strategy where the hedge fund manager invests in the equity or debt of struggling companies at steep discounts to estimated values.
2. Reasonable value – Strategy where the hedge fund manager invests in securities that are selling at discounts to their estimated values as a result of being out of favor or being relatively unknown in the investment community.
3. Merger arbitrage - Strategy where the hedge fund manager invests in merger-related situations where there are unique opportunities for profit.
4. Opportunistic events - Strategy where the hedge fund manager invests in securities given short-term event-driven situations considered to offer temporary profitable opportunities. An example of this may be if a piece of legislation is about to change and particular companies are likely to benefit.

Hybrid

1. Multistrategy - Strategy where the hedge fund manager employs two or more of the above strategies at one time. Managers may elect to employ a multi-strategy approach in order to better diversify their portfolio or to avoid constraints on their investment opportunities.
2. Funds of funds - Strategy where the hedge fund manager invests in two or more stand-alone hedge funds rather than directly investing in securities.
3. Values-based - Strategy where the hedge fund manager invests according to certain personal values and principles.

After watching a short excerpt of a Warren Buffet speech, I thought I may quickly summarise the collapse of the famous Hedge Fund, Long Term Capital Management. But First, Watch this excerpt, it is both funny and informative.

I have sourced most of the information below from an excellent paper done by Gregory Connor and Mason Woo (LSE) called An Introduction to Hedge Funds. I will separately write an introduction to Hedge Fund Strategies article after this article to have a more detailed look at Hedge Funds.

Long Term Capital Management

During the late 90’s, the largest tremor through the hedge fund industry was the collapse of the hedge fund Long-Term Capital Management (LTCM). LTCM was the premier quantitative-strategy hedge fund, and its managing partners came from the very top tier of Wall Street and academia. These funds are commonly known as “quant funds” or quantum funds and they typically use ma thematic strategies based on past market performance to predict future performance. They are typically very short term and are capable of providing very high returns.

From 1995-1997, LTCM had an annual average return of 33.7% after fees. At the start of 1998, LTCM had $4.8 billion in capital and positions totalling $120 billion on its balance sheet [Eichengreen, 1999].

Long Term Capital Management Strategy and Leverage ratio

LTCM largely (although not exclusively) used relative value strategies, involving global fixed income arbitrage and equity index futures arbitrage. As an example, LTCM exploited small interest rates spreads, some less than a dozen basis points, between debt securities across countries within the European Monetary System. Since European exchange rates were tied together, LTCM counted on the reconvergence of the
associated interest rates.

Its techniques were designed to pay off many sets of small returns, with extremely low volatility. To achieve a higher return from these small price discrepancies, LTCM employed very high leverage. Before its collapse LTCM controlled $120 billion in positions with $4.8 billion in capital. In terms of calculating this leverage, this represented an extremely high leverage ratio (120/4.8 = 25). Banks were willing to extend almost limitless credit to LTCM at very low interest rates, because the banks thought that LTCM had latched onto a certain way to make money.

LTCM was not an isolated example of size-able leverage. At that time, more than 10 hedge funds with assets under management of over $100 million were using leverage at least ten times over [President’s Working Group, 1999].

The Collapse of Long Term Capital Management

In the summer of 1998, the Russian debt crisis caused global interest rate anomalies. All over the world, fixed income investors sought the safe haven of high quality debt. Spreads between government debt and risky debt unexpectedly widened in almost all the LTCM trades.

LTCM lost 90% of its value and experienced a severe liquidity crisis. It could not sell billions in illiquid assets at fair prices, nor could it find more capital to maintain its positions until volatility decreased and interest rate credit spreads returned to normal.

Emergency credit had to be arranged to avoid bankruptcy, the default of billions of dollars of loans, and the possible destabilisation of global financial markets. Over the weekend of September 19-20, 1998, the Federal Reserve Bank of New York brought together 14 banks and investment houses with LTCM and carefully bailed out LTCM by extending additional credit in exchange for the orderly liquidation of LTCM’s holdings.

This bail out of Long Term Capital Management is similar to the recent bail out by the New York Federal Reserve of Bear Sterns. I will not go into whether or not one was more justified than the other but I read an excellent article Brave New Fed which is worth reading if you are interested.

Since the collapse of LTCM, hedge fund leverage ratios have fallen substantially.The aftermath of the Russian debt crisis and LTCM debacle temporarily stalled the growth of the hedge fund industry. In 1998, more hedge funds died and fewer were created than in any other year in the 1990s [Liang, 2001].

The number of hedge funds as well as assets under management (AUM) declined slightly in 1998 and the first half of 1999. After that the growth of hedge funds resumed with no major changes to regulations but with guidelines for additional risk management. [Lhabitant, 2002; Financial Stability Forum, 2000].

To see an excellent written summary of the Warren Buffest speech, see Warren Buffett on long term Value Investing or to see another Warren Buffett Video, click here.

Buying stocks through margin lending

Margin transactions involve buying securities with borrowed money.

Brokerage firms can lend their customers money to purchase securities and keep the securities as collateral, allowing the customer ride the inherent risk of the stock without the requirement of purchasing 100% of the stock.

The example below taken from a study guide to corporate finance that I am reading outlines how margin lending operates in U.S and defines some of the key concepts in margin lending.

The required equity position and the initial margin requirement

The margin lending rate is usually 1.5 percentage points above the bank call money rate (which is about 1 percentage point below the prime rate). In the U.S., margin lending limits are set by the Federal Reserve Board under Regulations T and U. The required equity position is called the margin requirement. The initial margin requirement is currently 50 percent. This means the borrower must provide 50 percent of the funds in the trade. An initial margin requirement of 40 percent would mean that the investor must put up 40 percent of the funds and the brokerage firm may lend the 60 percent balance.

After the trade, the price of the stock will change, causing the balance of the margin account to fluctuate. Should the stock price go up, the customer’s profits accumulate at a faster pace than a 100 percent equity position. This is the benefit of margin trading–leverage as it allows investors to gain more from the stock they choose to invest in than they would be able to with their capital alone.

The margin lending leverage ratio

The leverage ratiocan be calculated as [1/ margin %]. For example, at a 40 percent initial margin requirement, profits will accrue at a [1/.4] 2.5 leverage rate or 150 percent faster rate than a 100 percent equity position. The customer can remove any funds in the account in excess of the original margin requirement.

The rate of return on margin transactions

Assume that an investor purchases 100 shares of a stock for $75 per share (total cost = $7,500). If the stock is then sold for $150 per share (total value of $15,000), the investor would have had a 100 percent return on her initial investment [(15,000/7,500)-1*100].

Now, assume she purchased the same 100 shares with an initial margin of 50 percent. The cost of her investment would be only $3,750. The other $3,750 of the purchase will be borrowed from the brokerage firm. If the shares were then sold at $150 per share, her position would be worth $11,250 (i.e., 15,000-3,750). In this situation, the investor would have had a 200% return on her investment [(11,250/3,750)-1*100]. This calculated return is before commission costs and interest paid on the loan to the brokerage firm.

Determining the stock price at which an investor would receive a margin call.

A maintenance margin is the required fraction of an investor’s equity compared to the total value of the stock. The Federal Reserve has currently set the maintenance margin (the minimum equity portion of the account) at 25 percent on a stock purchase. If the customer’s balance falls below the maintenance margin, the customer will receive a margin call. The following formulas indicate the stock price that will trigger a margin call:

Long = [(original price)(1 - initial margin %)]/[1 - maintenance margin %]

Short= [(original price)(1+ initial margin %)]/[1 + maintenance margin %]

Question:

You buy a stock for $40. If the initial margin requirement is 50 percent and the maintenance margin requirement is 25 percent at what price will you get a margin call?

Answer: [($40)(1 - .5)]/[1 - .25] = $26.67.

Question:

You short a $40 stock. If the initial margin requirement is 50 percent and the maintenance margin requirement is 30 percent, at what price will you get a margin call?

Answer: [($40)(1 + .5)]/[1 + .30] = $46.15.

Welcome to part two of my blog when and why to sell a stock short which gives a good fundamental analysis of short selling stock.

Short selling strategies

Short selling strategies are used in speculation, hedging, arbitrage and ‘against the box’ strategies. Many investors believe that a good combination of short and long positions on stock is beneficial to your stock portfolio.

The first three strategies are quite simple and i have sourced some definitions from wikipedia below. The final against the box strategy is more interesting and I tried to give a clear outline of it myself:

Speculation

A seller intentionally takes on the risk of the stock moving up or down in price in the belief that the value of the shorted stock will fall. An example of this is short selling the stock of a company before its earnings reports are released if you believe the reports will fall below the expectations of market analysts.

Hedging

Short selling often represents a means of minimizing the risk from a more complex set of transactions. Examples of this are:

• A farmer who has just planted his wheat wants to lock in the price at which he can sell after the harvest. He would take a short position in wheat futures.

• A market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. This can create substantial bond positions. The largest risk is that interest rates overall move. The trader can hedge this risk by selling government bonds short against his long positions in corporate bonds. In this way, the risk that remains is credit risk of the corporate bonds.

Arbitrage

A short seller may be trying to benefit from market inefficiencies arising from the mispricing of certain products. An example of this is:

• an arbitrageur who buys long futures contracts on a US Treasury security, and sells short the underlying US Treasury security.

Against the box

One variant of selling short involves also using a long position. “Selling short against the box” is defined as holding a long position and entering a short sale order on the same stock.

The purpose of this technique is to lock in the paper profits on the long position collected so far without having to sell that position (and possibly incur taxes if the position has appreciated). Whether prices increase or decrease from this point, the short position balances the long position and the profits are locked in minus the brokerage fees and short financing costs.

The term box alludes to the time when a safe deposit box was used to store (long) shares.

It is intrinsically a very risky move as you are betting against the upward trend of the stock market in the hopes that a stock will go down in price but when used strategically with other long positions or on a case by case basis, it can be very profitable.

When I think of describing the concept of short selling, I almost think of it as the opposite of investing because you believe a company’s stock price will rise. That is, you believe the stock price of a company is overvalued and that it will drop when the market corrects.

Thus, the seller is selling high and then buying low. The profit will be the difference between the price you eventually buy the shares for and the (higher) price you sold them for (minus brokerage fees).

The problem however, is that when value investing in a stock, you can hold the stock forever waiting for it to increase and your losses are limited to the capital you contributed whilst when you are short selling, your losses are not limited and waiting longer time frames become very risky and costly.

Edit 22 September 08 – Short selling no longer possible on the ASX.

Short selling stock procedure

Short sales are orders to sell securities that the seller does not own. It order to do this, a seller must follow the short-sale procedure below:

1. The seller must borrow the securities from a broker before their sale.
2. The seller must inform their broker that the order is a short sale before the transaction is placed. The broker must also be a broker that engages in short sales of shares.
3. The seller must return the securities at the request of the lender or when the short sale is closed out. The short seller does not get the proceeds of the short sale.

Rules of short selling
The following three rules apply to short selling:

1. The uptick rule states stocks can only be shorted in an up market. Therefore, a short sale can only trade at a price higher than the previous trade. ‘Zero ticks’ occur where there is no price change and are defined as keeping the sign of the previous order. This rule is in effect to prevent traders known as “pool operators” from driving down a stock price through significant short selling, and then buying the shares for a large profit.
2. The short seller of stock must pay all dividends due to the lender of the security. This is because you effectively have a negative number of the shares.
3. The short seller of stock must also deposit margin money to guarantee the eventual repurchase of the security.

When to short sell stock

Having outlined the risks of short selling, the following types of companies were identified by Investor Guide as targets for the short sale of their stock:

1. Small capitalisation companies that have been driven up by speculative investors, especially companies that are difficult to value or those with minimal revenue (see P/E below).
2. Companies whose P/E ratios are much higher than can be justified by their growth rates.
3. Companies with bad or useless products and services.
4. Companies riding the latest trend that are unlikely to last.
5. Companies that have new competition entering the market.
6. Companies with weak or worsening financials (bad balance sheet, negative cash flows, etc.).

It is never a good idea to short a stock which is about to be taken over by another company as the offer may come at a significant premium and significantly increase the stock price; leaving you in an exposed position.

See part two for the short selling strategies that are typically employed by investors.

I am going to describe the potential risks and rewards associated with the four basic options strategies.

Options are one of the most versatile trading instruments ever invented. They provide a high-leverage approach to trading that can significantly limit the overall risk of a trade, especially when combined with stock or futures. As a result, understanding how to develop profitable strategies using options can be extremely rewarding. The key is to develop an appreciation about how these investment vehicles work, what risks are involved, and the vast reward potential that can be unleashed with well-conceived and time-tested trading strategies.

The four basic strategies that are fundamental to your options trading knowledge are:

1. Long Call (buying a call)
2. Short Call (writing a call)
3. Long Put (buying a put)
4. Short Put (writing a put)

X-axis – time, Y-axis – security price



I have sourced the information below from The Bible of Options Strategies – The Definitive Guide for Practical Trading Strategies by Guy Cohen. It neatly summarises the graphs above and outlines when you should be looking to use each of the 4 basic options strategies.

1- Buying a Call

• Belief that stock will rise (bullish outlook)
• Risk limited to premium paid
• Unlimited maximum reward

2- Writing a Call

• Belief that stock will fall (bearish outlook)
• Maximum reward limited to premium received
• Risk potentially unlimited (as stock price rises)
• Can be combined with another position to limit the risk

3- Buying a Put

• Belief that stock will fall (bearish outlook)
• Risk limited to premium paid
• Unlimited maximum reward up to the strike price less the premium paid

4 -Writing a Put

• Belief that stock will rise (bullish outlook)
• Risk “unlimited” to a maximum equating to the strike price less the premium received
• Maximum reward limited to the premium received
• Can be combined with another position to limit the risk

The four options strategies and the time decay of options
Using the above information and some basic knowledge of option pricing we can make decisions about maximising profit from the use of a combined options strategy. For example, an option has a greater value to the buyer with more time left to expiry as there is more chance that the option will be able to be exercised to yield a profit for the buyer.

There is a rule when trading options known as the ‘rule of opposites’ where if one thing isn’t true, then the opposite must be true. Thus, we can say that when options are reducing in time to expiry (increasing time decay), it is a good time for selling options and bad for buying options the closer you get to the expiry time.

Since the value of an option significantly decreases during the last month to expiration, a strong options strategy is not to own such time decayed options but rather to sell them.

Using the strategies above, we would buy calls and puts with at least three months (or more) left to expiration, thereby looking for the options to increase in
value during that time. Similarly, we would short calls and puts with a month or less to expiration, thereby looking for short-term income as the option hopefully expires worthless.

For an introductory look at options, try the James Cox finance blog on How To Understand Options In Only 5 Minutes Starting From Scratch

Understanding what options are, how options are used, and why options may be appealing in a successful trading strategy never used to be easy to understand for me (and I don’t think for many others for that matter). After doing a course in financial mathematics a couple of years ago, I could calculate the value of options, their likely cost price and I’m sure I understood their relationship with interest rates and other market factors.

That said, as I was not regularly trading options and thus not crystallising my knowledge of them, my knowledge slipped over time until I recently read “Finance – The Options Course – High Profit And Low Stress Trading Methods” by George Fontanills and The Bible of Options Strategies – The Definitive Guide for Practical Trading Strategies by Guy Cohen. I have sourced much of the below information from these books.


Understanding options

My reading uncovered that options are probably the most versatile trading instrument ever invented. They provide a high-leverage approach to trading that can significantly limit the overall risk of a trade, especially when combined with trading stock (shares) or trading futures. In essence, understanding how to best use options can obviously be very beneficial.

The key is to develop an appreciation about how these investment vehicles work, what risks are involved, and the vast reward potential that is available through well-conceived and proven trading strategies.

Options and Option rights (and futures)

First, it is important to differentiate between futures and options. A futures contract is a legally binding agreement that gives the holder the obligation to actually buy (and take delivery of) or sell (be obligated to deliver) a commodity or financial instrument at a specific price. Common futures contracts are made over commodities like Oil and a variety of different produce.

In contrast, purchasing an option is the right, but not the obligation, to buy or sell a financial instrument (stock, index, futures contract, etc.) at a specific price. The key here is that buying an option is not a legally binding contract. In contrast, selling (writing or shorting) an option obligates the seller to provide (or buy) the instrument at the agreed-upon price if asked to do so.

Option buyers have rights and option sellers have obligations. Option buyers have the right, but not the obligation, to buy or sell a stock, index, or futures contract at a predetermined price before a predefined expiration date. In contrast, option sellers, sometimes called writers, have the obligation to buy or sell the underlying stock shares (or futures contract) if an assigned option buyer or holder exercises the option.

The key here is that in buying an option you have a limited risk potential equal to the price you paid for the option. Whereas, when selling an option you’re risk is theoretically unlimited if the price of the instrument the option relates to moves in the ‘wrong’ direction for you and the buyer of the options exercises his right.

Types of Options

There are two types of options contracts; puts and calls. Click to open some examples of options in a new window.

A put option is an options contract that gives the owner the right to sell (or put) the underlying asset at a specific price for a predetermined period of time. A call option gives the option holder the right, but not the obligation, to buy a stock at a predetermined price for a specific period of time.

It must also be remembered that you can both buy and sell both option puts and option calls leaving you with 4 fundamental options trading positions that will be anlaysed in detail in a later blog on option risk profiles. These are known as:

1. long put (buying a put option)
2. short put (selling a put option)
3. long call (buying a call option)
4. short call (selling a call option)

Option strike price

In addition to understanding the underlying asset, traders must also understand the trading terms used to describe an options contract. For example, every option has a strike price, which is the price at which the stock or future can be bought or sold until the option’s expiration date. Options are available in several strike prices depending on the current price of the underlying asset and have varying costs based on the strike price.

As a result, the profitability of an option depends primarily on the rise or fall in the price of the underlying stock or futures contract in relation the strike price of the option. Determining an option’s premium also depends on the time left until expiration, volatility, and other factors which will be discussed in a later options blog.

I found the following summary very useful in understanding options. There will also be many more blogs coming on options and if you wish to stay in touch, please subscribe to my RSS feed below.


12 guidelines to understanding options

1. Options give you the right to buy or sell an underlying instrument at a specific price.

2. If you buy an option, you are not obligated to buy the underlying instrument; you simply have the right to exercise the option.

3. If you sell a call option, you are obligated to deliver the underlying asset at the price at which the call option was sold if the buyer exercises his or her right to take delivery. If you sell a put you must buy the underlying if exercised.

4. Options are good for a specified period of time after which they expire and the holder loses the right to buy or sell the underlying instrument at the specified price.

5. Buying options is completed at a debit to the buyer. That is, the money is debited from the brokerage account.

6. Selling options is completed at a credit to the seller. Money is added to the brokerage account.

7. Options are available in several strike prices at or near the price of the underlying instrument.

8. The cost of an option is referred to as the option premium. The price reflects a variety of factors including the option’s volatility, time left until expiration, and the price of the underlying asset.

9. There are two kinds of options: calls and puts. Calls give you the right to buy the underlying asset and puts give you the right to sell the underlying asset.

10. All the put or call options with the same underlying security are called a class of options. For example, all the calls for IBM constitute an option class.

11. All put and call options that are in one class and have the same strike price and expiration are called an option series.

12. Options are available on a variety of different underlying assets including stocks, futures, and indexes.