In fact, individual investors can benefit from studying these failures, since exactly the same factors that cause major hedge funds to fail also apply to retail investors.
How do hedge funds use leverage?
By definition, the only way that hedge funds can generate the high returns that their clients demand is to use leverage. One example of this is a currency carry trade. This is where a fund borrows money in one currency at a low interest rate, and then uses the money to buy another currency that has a higher interest rate. The return that they can make is essentially the difference between the two interest rates minus the cost of borrowing the money. Even when the spread between the two interest rates is relatively high, the return without leverage is rarely more than 3% to 4%.However, by using leverage, hedge funds easily double this return. However, no matter how good these trades look in principle, the sad fact is that they can and do go wrong. When this happens, the hedge fund can run into significant problems unless they have a proper risk management strategy in place. There are many different ways of managing risk, ranging from very simple to extremely complicated, but all of these strategies are designed to limit losses if the market behaves in a completely unexpected way.
What lessons can individual investors learn?
First of all, successful hedge funds know how to structure their positions so that they survive when the market exhibits unprecedented behavior. This is particularly important when it comes to margin calls – which are an unavoidable consequence of using leverage. A large number of hedge fund failures come about because they can’t meet these margin calls, resulting in them having to exit positions at the worst possible time.The second lesson is a direct consequence of the first one – always make sure you have enough reserves on hand to rescue any leveraged position. What this means is that it is fine to have part of your portfolio in highly leveraged positions, but make sure that your entire portfolio isn’t tied up in these – particularly if they are poorly diversified.
Finally, don’t get greedy. If you try to increase your takings too much through leverage, you will end up in serious trouble. Plan for all contingencies – including ones that you can’t predict – and make sure that your trades are set up so that you can survive the worst scenario. This may reduce your potential profits, but it will also ensure that you aren’t wiped out when things go wrong.
Editors’ Picks
AUD/USD pressures as Fed officials hold firm on rate policy
The Australian Dollar is on the defensive against the US Dollar, as Friday’s Asian session commences. On Thursday, the antipodean clocked losses of 0.21% against its counterpart, driven by Fed officials emphasizing they’re in no rush to ease policy. The AUD/USD trades around 0.6419.
EUR/USD extends its downside below 1.0650 on hawkish Fed remarks
The EUR/USD extends its downside around 1.0640 after retreating from weekly peaks of 1.0690 on Friday during the early Asian session. The hawkish comments from Federal Reserve officials provide some support to the US Dollar.
Gold price edges higher on risk-off mood hawkish Fed signals
Gold prices advanced late in the North American session on Thursday, underpinned by heightened geopolitical risks involving Iran and Israel. Federal Reserve officials delivered hawkish messages, triggering a jump in US Treasury yields, which boosted the Greenback.
Bitcoin Price Outlook: All eyes on BTC as CNN calls halving the ‘World Cup for Bitcoin’
Bitcoin price remains the focus of traders and investors ahead of the halving, which is an important event expected to kick off the next bull market. Amid conflicting forecasts from analysts, an international media site has lauded the halving and what it means for the industry.
Is the Biden administration trying to destroy the Dollar?
Confidence in Western financial markets has already been shaken enough by the 20% devaluation of the dollar over the last few years. But now the European Commission wants to hand Ukraine $300 billion seized from Russia.
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