Earning The Points

finance a la shmoop. how does a hedge fund work? so you've probably heard a lot

about the huge fees that hedge funds charge for the privilege of managing [woman looks shocked as hedge fund is advertised]

your money. that hedge funds are only investing vehicles for the wealthy and

how mathy their employees are. but the actual workings of a hedge fund are a

lot like driving down a road in wartime. there are hills and there are valleys

your car will Traverse wanting it to speed up and slow down but as long as

you continue to drive 37 miles an hour the enemy radar can't detect you so you

drive theoretically, safely down the road. alright so how does this translate to

financial investments in a hedge fund well essentially every investment made

on an entity going up in value is usually offset by making a bet on a

different entity going down in value. that's called hedging got it? the economy

is coming out of the doldrums and you believe the entire stock market is gonna

recover but you believe the worst companies which have been down some 90% [chart showing decline]

in this bad bear market environment will actually do better over the next period

of time than high quality companies like Coca Cola which didn't decline as much.

that is yes Coca Cola stock will improve and you think it has Headroom to run

upwards some 30% in the next year and a half but you believe crap burgers

dot-com which went from $100 a share at its peak to only $2 today could

quadruple to 8 bucks in value over that same 18 months. like you get a much

better percentage return on crap burgers than you do on coke. so as a hedge fund

manager one quote easy unquote trade that you'll make is too short coca-cola

betting essentially that it will go down, and then putting the same amount of

money to being long crap burger com betting essentially that it'll go up. in

essence the bet that you are making is that crap burger will go up a lot more [Coca-Cola and crap burger stocks in two separate baskets]

than coca-cola will go up but if the overall market goes down

well you'll be hedged in that you're short Coca Cola position will cushion

the blow of crap burgers further demise and it's likely you're looking at crap

burgers balance sheet and thinking well they have $2 a share in cash and no debt

how much lower can they go .got it? hedge funds use stock options

aggressively to manage risk in their portfolios the promise hedge funds make

to investors is that their performance will be up and/or good whether the

market goes up down or stay sideways. so another common hedge trade involves the

use of put options on the market to protect the long trades the fund is

making. specifically a hedge fund might find 3 S&P 500 stocks it really likes [ put option explained]

and believes that they will be up significantly over the next two to three

quarters earnings reports. but it's also nervous about nukes in North Korea in

order to protect against a bomb going off and the whole market going down and

ruining its investment performance, and yes there are bigger things to worry

about then but that doesn't matter to hedge funds not their job. the hedge fund

goes long the three stocks it likes but it buys put options on the market

betting with those options that the market itself will go down. it's

essentially playing both sides of the fiddle so that hopefully it wins in any

set of circumstances. and yeah it's a lot more complicated than that in practice

we're just given the idea here. in the case of a put option the market might be

trading at ten thousand and a put option might have a strike price of nine

thousand such that if the market declines below nine thousand the put [strike price illustrated]

option goes quote in the money unquote and pays the investor handsomely for

making the bet that the market would go from ten thousand and well somewhere

below nine thousand. if that happened the three long stock bets that the hedge

fund made would go down but their decline would be hopefully more than

offset by the gains from the put options the hedge fund bought that were

portfolio life insurance in the case the market puked. and if that happens well

all you can really do is offer the market a breath mint and a moist

towelette and then be sure to collect your fee. [person representing stock market offered towelette]