The financial markets consist of numerous different securities on top of many different trading strategies applied to earn profits. Hedging transactions are strategies used by portfolio managers, such as hedge fund managers, to protect one trade in the markets by applying a second trade. Hedging is a way to minimize losses, but it may not maximize returns. One common form of hedging is an equity long-short strategy, and there are different ways traders use this method.
Hedge funds are lightly regulated investment vehicles that use complex trading strategies to generate above-average returns or profits in the financial markets. Investors know the risk when selecting these funds, and a large initial investment is required. Hedge funds charge investors two layers of fees in exchange for the profits realized from hedging transactions. The fee structure is typically a 2 percent management fee and a 20 percent investment performance fee.
Equity long-short investing is one of many hedging transactions. In this strategy, a portfolio manager attempts to hedge or protect a position in the financial markets by going long in one trade and short in another. The long investment is a bet that a security will rise in value, and the short bet is a trade based on an expectation that a security will decline. Ultimately, the hedge fund manager believes the markets are undervaluing one stock, his long position, and overvaluing another, his short position. In this scenario, an investor is hedging the long position with a short bet and stands to profit if the stocks behave as expected or even deviate slightly from expectation.
Hedging transactions also include pairs trading. In this form of equity long-short investing, the portfolio manager researches and selects a pair of stocks that trade in the same industry or are alike in some other way. One of the stocks should show signs of strength, while the other should demonstrate weakness. The money manager places a long bet on the strong stock and hedges that position with short bet on the weaker security.
Portfolio managers can add additional risk to hedging transactions. Leverage or debt could be added to a short trade in order to enhance profits and not only mitigate losses. Hedge funds borrow securities from a broker, known as a prime broker, to add this leverage to a bet. If the investment works as expected and the shorted stock declines, the hedge fund manager can buy the shares at a lower price and repay the broker. The portfolio manager must still repay the broker the borrowed shares even if the trade fails.