How to Trade Like a Hedge Fund

Have you ever wondered how major hedge fund managers make their decisions? The stakes are incredibly high for fund managers which means their margin for error is slim. We’ve even seen major hedge funds like Ray Dalio’s Bridgewater Associates experience massive Q1 losses this year, which shows us just how quickly the market can go against you when you have highly levered positions.

Although you might not be working with billions of dollars in assets under management, you can still pick up some valuable lessons by learning some of the basic concepts that major hedge funds rely on.

What is a Hedge Fund?

A hedge fund is an investment vehicle that uses a pool of funds from contributing investors who are usually selected based on specific criteria such as high-net-worth. They are not publicly accessible, which means hedge funds can avoid a lot of the regulations that other funds like mutual funds are subject to. People that invest in hedge funds are usually required to keep their money invested for a specific time period, typically at least one year. Hedge funds have been known to generate massive returns for their investors through the use of leverage, although leverage can also work against them like we have seen for a few funds this year.

Trading Techniques of Hedge Funds

There are quite a few different strategies and techniques that hedge funds use on a regular basis. Let’s take a look at some of these trading techniques below.

Use of Derivatives

One of the key trading techniques of hedge funds has to do with derivatives like futures contracts and options. The major fund managers often take advantage of derivative contracts as a means of lowering their risk on their open positions. They essentially hedge against open positions in order to protect profits or minimize losses if a position goes against them. Since derivatives trade at a fraction of the financial instrument’s actual price, fund managers can protect their downside risk without large cash outlays. You can use derivatives the same way on a much smaller scale in order to protect some of the large positions in your account or use them for pure speculation trades.

Masters of Managing Trades

Another important technique that every hedge fund manager works to perfect is their ability to manage trades. Hedge funds are experts and entries and exits. They will quickly cut losses and allow profits to run without a second thought. Part of the reason why hedge fund managers are so good at managing their trades is because they spend a lot of time and resources analyzing each new position and determining the risk and reward of each trade. You can take this idea and adapt it to your own trading and investing by spending time creating a trading plan before opening any new position. One of the big issues for many retail investors and traders is that they don’t think about when they will exit a trade if it is indeed profitable. You can avoid giving back profits and taking huge losses with a clearly defined profit target and exit strategy in mind before you enter any trade.

Multiple Uncorrelated Trades

Hedge fund managers are known to achieve a lot of success by opening positions in several different uncorrelated trades. Most professional hedge fund traders will have anywhere from 10-20 individual trades at a time that form a portfolio. The idea here is that with a lot of different uncorrelated trades, you can reduce your total market risk at any given time. They are taking the concept of diversification and using it to their advantage on a large-scale. This can be a difficult strategy for retail traders with limited account sizes, but you can still use the concept of limiting your risk through multiple uncorrelated positions to your advantage.

Putting It All Together

You might be thinking that hedge funds are successful because of the resources and amount of money they have to trade with. Although those are helpful tools that allow hedge funds to generate massive returns, retail traders actually have some powerful advantages over hedge funds. As a retail trader, you are able to enter and exit positions easily due to your position size. You aren’t limited to what you can buy and sell. Also, you aren’t facing scrutiny from your investors for your performance. Hopefully, you can use the techniques and concepts mentioned above to improve your own trading going forward.