CHAPTER 1
Trading and Hedge Funds

This chapter introduces how trading organizations, such as hedge funds or the proprietary trading desks of investment banks, apply risk management concepts to operate their businesses. Risk is uncertainty or a potential for loss. Risk isn’t necessarily bad. Risky activities often provide higher profits than safe investments. Techniques developed to manage risk are used by trading desks to drive profitability by balancing risk and reward. Some of these techniques include choosing the most profitable investments, allocating a limited amount of money between multiple investments, eliminating risks through hedging, and assigning size limits to various investment strategies.

There are a limited number of decisions that can be made by trading desks to manage risk. Profitability starts when traders do a good job identifying investment opportunities. After that point, common decisions are: how to allocate capital between investment opportunities, limiting how much money is allocated to any single investment, and reducing the size of investments by liquidating or placing protective trades.

OVERVIEW OF BOOK

This book describes how risk management techniques are used by professional traders to reduce risk and maximize profits. The focus of the book is how traders working at hedge funds or on investment bank proprietary trading desks use risk management techniques to improve their profitability and keep themselves in business. However, these techniques can be applied to almost any trading or investment group.

This book focuses on six major activities that are part of managing trading businesses.

1. Backtesting and Trade Forensics. Backtesting is a disciplined approach to testing trading ideas before making bets with actual money. Trade forensics is a post-mortem analysis that identifies how well a trade is tracking pre-trade predictions and if markets have changed since the trade was initiated.
2. Calculating Profits and Losses. Once a trade has been made, traders have to calculate the daily profits and losses. For some financial instruments, this is as simple as checking the last traded price from an exchange feed. For other investments, calculating the fair value of the trade is challenging.
3. Setting Position Limits. The size of investments that traders can make are typically limited by the volatility of their expected daily profits and losses. In other words, risk can be a way to measure size. As a result, the goal of hedge fund traders is to maximize the profits relative to a fixed amount of risk.
4. Hedging. Hedging is a trading strategy designed to limit profits and losses in one investment by taking an offsetting position in another asset. For example, a hedge fund might want to lock in profits associated with a physical asset like an oil well that they can’t sell right away. They can agree to sell oil at a fixed price and remove the risk of price fluctuations.
5. Managing Option Risk. Certain types of financial instruments, particularly options, present much more complicated risk management challenges for traders. Risk managers have developed a variety of techniques to model this risk and fit options risk with other position limits.
6. Managing Credit Risk. Trading can’t be done in isolation. Every time someone wants to buy an asset, someone else needs to sell. Not all trades settle right away—trading often involves obligations that are taken on in the future. As a result, traders depend on their trading partners meeting their trading obligations, and are exposed to the risk that their trading partners will default on their obligations.

TRADING DESKS

Professional traders often work on teams called trading desks. A trading desk is a group whose members are traditionally seated side-by-side at a series of long desks (usually filled with computer equipment) that is responsible for buying and selling financial products for an organization. Trading desks will typically specialize in one or two types of financial products. Some trading desks will specialize in stocks, others in bonds, and so on.

Many types of companies will maintain trading desks. Some of these desks will focus on supporting the company’s other lines of business—buying fuel for a trucking company or financial products on behalf of investors, for example. However, a couple types of trading desks are operated as their own line of business. The most prominent of these are mutual funds, hedge funds, and proprietary trading desks at banks.

Some organizations whose focus is on trading for profit are:

• Mutual Funds. Mutual funds are a pooled-investment fund where the leadership of the fund manages investments on behalf of investors. These funds are restricted from many investment strategies deemed too speculative or risky for uninformed investors.
• Proprietary Trading Desks. A trading desk found in many investment banks that operates like an internal hedge fund to invest the firm’s capital.
• Hedge Funds. Hedge funds are pooled investment funds similar to mutual funds. They differ in that they do not cater to the general public—only to accredited investors. Many hedge funds seek to profit in all kinds of markets by using leverage (in other words, borrowing to increase investment exposure as well as risk), short-selling, and using other speculative investment practices that mutual funds are restricted from using.

One of the largest differences between hedge funds and proprietary trading desks compared to mutual funds or individual investors is that they will often make trades designed to make profits when prices decline. This is called shorting the market and allows profitability in both rising and falling markets. Shorting is not exclusive to hedge funds and trading desks—it can be done by individual investors. For example, shorting is commonly practiced in various commodity markets.

Shorting involves agreeing to sell something that the trader does not currently own. For example, a soybean farmer might agree to sell his crop (which hasn’t been grown yet) for a fixed price per bushel when the crop is harvested. If prices fall after that point, the sales contract will acquire value to the farmer. If the contract allows him to sell 10,000 bushels of soybeans at $20 per bushel and prices fall to $10 per bushel, the contract is worth $10 per bushel (or $100,000) to the farmer. The contract is an asset to the farmer, and if a trading market exists for those contracts, could be sold to another trader.

HEDGE FUNDS

Hedge funds are a prototypical trading organization. They have few restrictions on their activities and typically have no source of income other than their skill at trading. In this book, hedge funds are used as an example of firms that use risk management techniques to help them compete more effectively.

KEY CONCEPT: LEVERAGE AND SHORTING

Two activities differentiate professional trading groups from most other types of investors. First, professional traders often finance trading positions through borrowed money. Second, professional traders have the ability to make trades that benefit from both rising and falling markets.

• Leverage is any activity (like borrowing money) that increases the size of the investment without increasing the capital that needs to be contributed by investors. This is sometimes called gearing.
• Shorting is entering into a trade that makes money when prices decline.

Hedge funds are private partnerships that invest in the financial markets. Like mutual funds, hedge funds pool money from investors and invest the money in an effort to make a profit. Their organizational structure varies from other investment structures because the investors in the fund are typically limited partners rather than clients. This allows hedge funds an extremely high level of flexibility in their operations and allows them to trade in markets deemed too risky for typical investors.

Hedge funds require that their investors meet certain qualifications before they are allowed to invest in the fund. By catering only to qualified investors, hedge funds can avoid many limitations designed to protect the average investor. The reasoning behind government rules to protect investors is that not all investors are sufficiently qualified to understand the risks associated with exotic or risky investments. In other words, the government limits investors from focusing only on an investment’s profit potential without regard for the associated risks.

Hedge funds offer investors, traders, and hedge fund managers the possibility of making a lot of money. However, the hedge fund industry is also a competitive and stressful environment where the most successful traders win big and unsuccessful ones go broke. Hedge funds use risk management to successfully run a complex and risky business.

KEY CONCEPT: ACCREDITED INVESTOR

An investor with substantial assets or sufficient financial expertise that they can voluntarily exempt themselves from rules designed to protect the average investor.

Hedge funds are usually arranged as limited partnerships. A limited partnership is composed of two tiers of investors. The first tier of investors, called the general partners, has management authority and is personally liable for any debts incurred by the firm. These general partners take on the most risk, but have a...