Options hedge fund strategy type

By Dan Barufaldi Hedge funds use a variety of different strategies, and each fund manager will argue that he or she is unique and should not be compared to other managers. The following is loosely defined and does not encompass all hedge fund strategies, but it should give the reader an idea of the breadth and complexity of current strategies. Learn more in Taking A Look Behind Hedge Funds.

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Strategies By Dan Barufaldi Share. Performance Measurement Hedge Funds: Why Choose Hedge Funds? The Due Diligence Process Hedge Funds: Funds Of Funds Hedge Funds: Market Neutral — In this strategy, a hedge fund manager applies the same basic concepts mentioned in the previous paragraph, but seeks to minimize the exposure to the broad market.

This can be done in two ways.

If there are equal amounts of investment in both long and short positions, the net exposure of the fund would be zero. Find out how this strategy works with mutual funds; read Getting Positive Results With Market-Neutral Funds.

There is a second way to achieve market neutrality, and that is to have zero beta exposure. In this case, the fund manager would seek to make investments in both long and short positions so that the beta measure of the overall fund is as low as possible.

In either of the market-neutral strategies, the fund manager's intention is to remove any impact of market movements and rely solely on his or her ability to pick stocks. In the world of hedge funds, where everyone is trying to differentiate themselves, you will find that individual strategies have their unique nuances, but all of them use the same basic principles described here.

Global macro funds invest in stocks, bonds, currencies , commodities , options, futures , forwards and other forms of derivative securities. They tend to place directional bets on the prices of underlying assets and they are usually highly leveraged. Most of these funds have a global perspective and, because of the diversity of investments and the size of the markets in which they invest, they can grow to be quite large before being challenged by capacity issues.

Many of the largest hedge fund "blow-ups" were global macros, including Long-Term Capital Management and Amaranth Advisors.

Both were fairly large funds and both were highly leveraged. For more, read Massive Hedge Fund Failures and Losing The Amaranth Gamble.

Relative Value Arbitrage This strategy is a catchall for a variety of different strategies used with a broad array of securities. The underlying concept is that a hedge fund manager is purchasing a security that is expected to appreciate, while simultaneously selling short a related security that is expected to depreciate. In each case, there is an equilibrium value that is easy to calculate since the securities are related but differ in some of their components.

Let's look at a simple example: Maturity is assumed to be the same for both bonds. Assume that a company has two outstanding bonds: They are both first-lien claims on the company's assets and they both expire on the same day. However, the amount of this premium is often out of equilibrium, creating an opportunity for a hedge fund to enter into a transaction to take advantage of the temporary price differences.

I have used a fairly large spread in the premium to reflect a point. In reality, the spread from equilibrium is much narrower, driving the hedge fund to apply leverage to generate a meaningful levels of returns.

About Hedge Funds - Synopsis of Hedge Fund Strategies

Convertible Arbitrage This is one form of relative value arbitrage. While some hedge funds simply invest in convertible bonds, a hedge fund using convertible arbitrage is actually taking positions in both the convertible bonds and the stocks of a particular company. A convertible bond can be converted into a certain number of shares. In a convertible arbitrage transaction, however, a hedge fund manager will purchase the convertible bond and sell the stock short in anticipation of either the bond's price increasing, the stock price decreasing, or both.

Keep in mind that there are two additional variables that contribute to the price of a convertible bond other than the price of the underlying stock. For one, the convertible bond will be impacted by movements in interest rates, just like any other bond. Secondly, its price will also be impacted by the embedded option to convert the bond to stock, and the embedded option is influenced by volatility. Even if they are incorrect and the relative prices move in the opposite direction because the position is immune from any company-specific news, the impact of the movements will be small.

A convertible arbitrage manager, then, has to enter into a large number of positions in order to squeeze out many small returns that add up to an attractive risk-adjusted return for an investor.

Once again, as in other strategies, this drives the manager to use some form of leverage to magnify returns. Learn the basics of convertibles in Convertible Bonds: Read about hedging details at Leverage Your Returns With A Convertible Hedge. Distressed Hedge funds that invest in distressed securities are truly unique. In many cases, these hedge funds can be heavily involved in loan workouts or restructurings , and may even take positions on the board of directors of companies in order to help turn them around.

You can see a little more about these activities at Activist Hedge Funds.

That's not to say that all hedge funds do this. Many of them purchase the securities in the expectation that the security will increase in value based on fundamentals or current management's strategic plans. In either case, this strategy involves purchasing bonds that have lost a considerable amount of their value because of the company's financial instability or investor expectations that the company is in dire straits.

In other cases, a company may be coming out of bankruptcy and a hedge fund would be buying the low-priced bonds if their evaluation deems that the company's situation will improve enough to make their bonds more valuable. The strategy can be very risky as many companies do not improve their situation, but at the same time, the securities are trading at such discounted values that the risk-adjusted returns can be very attractive.

Learn more about why funds take on these risks at Why Hedge Funds Love Distressed Debt. Conclusion There are a variety of hedge fund strategies, many of which are not covered here. Even those strategies that were described above are described in very simplistic terms and can be much more complicated than they seem.

Is Your Hedge Fund Secretly a Pricey Put-Selling Strategy? - Barron's

There are also many hedge funds that use more than one strategy, shifting assets based on their assessment of the opportunities available in the market at any given moment. Each of the above strategies can be evaluated based on their potential for absolute returns and can also be evaluated based on macro- and microeconomic factors, sector-specific issues, and even governmental and regulatory impacts.

Hedge funds seek positive absolute returns, and engage in aggressive strategies to make this happen. Hedge fund investors or potential investors need to understand how much risk hedge funds take in making money.

Hedge funds may be similar to mutual funds in some ways, but they differ in other ways like fee structure. Is a hedge fund for you? Most investors are aware of hedge funds, but many don't know the dirty details of this unique investment type. Find out how average investors are breaking into what was once reserved for the ultra rich. Long the purview of institutional investors and ultra-wealthy individuals, financial services firms are making alternative investment strategies available to a wider audience of investors.

Learn how hedge funds win big gains for investors - and why they sometimes lose.

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The Options Landscape for Hedge Funds | The Hedge Fund Journal

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