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
EUR/USD holds gains above 1.0700 as USD struggles ahead of data
EUR/USD is posting small gains above 1.0700 in the European session on Thursday. The pair remains underpinned by a sustained US Dollar weakness, in the aftermath of the Fed policy announcements and ahead of more US employment data.
GBP/USD stays firm above 1.2500 amid US Dollar weakness
GBP/USD is consolidating the rebound above 1.2500 in European trading on Thursday. The pair's uptick is supported by a broadly weakness US Dollar on dovish Fed signals. A mixed market mood could cap the GBP/USD upside ahead of mid-tier US data.
Gold price trades with modest losses amid positive risk tone, downside seems limited
Gold price edges lower amid an uptick in the US bond yields, though the downside seems cushioned. A positive risk tone is seen as another factor undermining demand for the safe-haven precious metal.
Top 3 Price Prediction BTC, ETH, XRP: Altcoins to pump once BTC bottoms out, slow grind up for now
Bitcoin reclaiming above $59,200 would hint that BTC has already bottomed out, setting the tone for a run north. Ethereum holding above $2,900 keeps a bullish reversal pattern viable despite falling momentum. Ripple coils up for a move north as XRP bulls defend $0.5000.
Happy Apple day
Apple is due to report Q1 results today after the bell. Expectations are soft given that Apple’s Chinese business got a major hit in Q1 as competitors increased their market share against the giant Apple.
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