Behind the Scenes of the Market: How Hedge Funds Trade

Have you ever wondered how hedge fund traders make so much money? The way a hedge fund can in fact hedge its bets and still pull out a profit really sounds counterintuitive.

Most retail investors are familiar with buying, selling, and even shorting stocks and bonds, investments that win or lose with the market. But few realize there's a whole world of other ways to invest that doesn't depend on whether the market is up today or down. These are the strategies that hedge funds use to make money.

When asset managers like Blackstone (NYS: BX) , Goldman Sachs, and JPMorgan Chase line up clients and funds with attractive risk profiles, the strategies I highlight below are just a few of the kinds of strategies they're looking at. Hedge funds come in all shapes and sizes, but here I'll try to scratch the surface of how they attempt to hedge trades and make money at the same time.

Statistical arbitrage
One of the oldest trading strategies is called statistical arbitrage, in which you trade various stocks within a basket of securities against each other. If one goes up you sell, while you buy another when it goes down, all based on an index or average value of the securities. At the end of the day, you don't care whether the index went up or down, only that the underlying securities moved around the index and eventually moved generally the same amount.

This is often done with large indexes like the Dow Jones Industrial Average and companies like 3M (NYS: MMM) and GE (NYS: GE) that have large businesses that will generally grow at around the same rate. This strategy takes advantage of the difference between daily ups and downs of each stock -- otherwise known as market volatility.

For example: At its simplest level, if I implemented a statistical arbitrage strategy based around the Dow Jones Industrial Average, with 3M down 1% and GE up 3% in a given day, I'd sell GE and buy 3M. When you do this enough times with enough different pairs of stocks, the theory is that eventually these stocks will balance out, and you will be buying low and selling high relative to the index. Traders don't care if the entire index goes up or down, as long as the volatility within the index continues.

Discounts in the market
A hedge fund may also try to take advantage of discounts in ETFs or closed-end funds like Gabelli Equity Trust (NYS: GAB) or Aberdeen Asia-Pacific Income Fund (ASE: FAX) . Especially in times of turmoil, closed-end funds may trade at a discount of 20%, 30%, or more to their net asset values, which are published daily.

Based on quarterly filings, hedge funds can get a general idea what a closed-end fund is invested in and hedge their risk by shorting corresponding stocks when buying the fund. This is like a mini-arbitrage strategy when the market gets a little wacko.

Given a long enough time frame, retail investors can also take advantage of these discounts when buying closed-end funds, but beware of the management fees and any risks the fund uses in managing its assets.

A guaranteed winner, sort of
Hedge funds are also quick to take advantage of new products on the market, like leveraged ETFs. These extremely risky investments have the dubious distinction of being almost guaranteed losers over the long term, and shorting them can be an easy profit.

But short-term ETFs like Direxion Daily Financial Bull 3X shares (ASE: FAS) and its counterpart DirexionDaily Financial Bear 3X Shares (ASE: FAZ) can soar, leaving the unprepared investor with massive losses. If you have the time and patience to wait out the inevitable decline, you can follow hedge funds by shorting leveraged ETFs -- but beware the borrowing costs involved in obtaining shares to sell short, as well as the potentially massive losses along the way.

How can you profit?
Some hedge fund trading strategies aren't possible for a retail investor to implement because we don't have the low transaction costs and large amounts of capital that hedge funds have. But most of their investments are fairly simple strategies that almost anyone can execute.

In my time working at a hedge fund, I found that it was less about complex investment knowledge and more about logic and sound reasoning that drove investments. Whether it's a long/short pair, buying funds at a discount, or making bets on individual stocks or bonds, hedge-fund-style investing isn't rocket science. It just takes research and a well-thought-out investment thesis.

At the time thisarticle was published Fool contributor Travis Hoium does not have a position in any company mentioned. You can follow Travis on Twitter at @FlushDrawFool, check out his personal stock holdings or follow his CAPS picks at TMFFlushDraw.The Motley Fool owns shares of JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Goldman Sachs and 3M, as well as creating a diagonal call position in 3M. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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