For all those who never heard about Hedge Fund Managers / Traders and what they do...

 

...It is not what you hear or think. It is a fundamental DIFFERENT way of trading stocks.

For the most part people are misinformed or afraid of the unknown. Some pretend to know and some simply choose to be ignorant in the information age. We have the world's library at our finger tips. Use it! Your choice.

A Hedge Fund is simply a money fund like any other (mutual or growth funds) that invest a pool of money. The difference is that beside clients money, a hedge fund trader also trades with his own money AND usually every position in the fund is hedged against market downturns and also against Sector losses. The difference to Financial Investment banks that wait for clients to send money in order to buy certain stocks or their own Funds, Hedge funds do not only go long on stocks, they hedge them. Mutual Funds or Investment Banks are ALL LONG. This means when the market goes down you WILL lose money. Not so with a hedge fund. A hedge fund trades a stock in a pair just like in the FOREX market when you buy AUD/USD. You buy the Aussie, AUD and at the same time you sell USD. You are long AND short. You buy AUD and you pay with USD! We do the same with stocks, we trade them as a spread /pair. I.e. you do AAPL/CHD, you buying APPLE and selling CHURCH & DWIGHT, a spread trade, a pair. Or see it this way: you buy AAPL and you pay in CHURCH & DWIGHT Dollars. It is an asset, a commodity like any other.

How do we find the right stock? OK.

We get our world view with the release of economic data. See sources below. Leading indicators that tell you 6-12 months in advance what is going to happen in the economy. With the ISM from the US, Europe and China and other leading indicators we determine if we are in a bullish or bearish market and how that plays out in different sectors and countries: Super Sectors and Industries. 

With the overall view on global economy we can pick our sectors also given by the ISM and other leading indicators. The red numbers show my sectors to short and the green sectors to long.

Below find the best Sectors to go long in the beginning of 2021.

Here you pick your winning industries and losing ones.  I.e. Cyclical Retailers vs Defensive Retailer, since we are still in a bullish market. OR, Cyclical Retailers vs Energy, and now with Biden add Oil and Gas as losers.

Here in this example with all the calculation, even though the pair is NOT very lucrative, we trade AAPL/AMT, Apple as a tech stock that is 70% market driven and since we still have a great S&P500 the market is bullish and you go long on Cyclical Retail Stocks, Apple. You go short on Defensive Retail or Energy or REIT Stocks.

What that does it eliminates the market volatility. If the market goes down both stock go down but AAPL more than AMT, you keep winning on the SHORT Position and losing on your LONG, and vice versa. Market goes up you are winning on your LONG Position and losing on your SHORT.

This balances the pair and eliminates the market. Where is the profit? The profit is made like in the FOREX Market BETWEEN the stocks, in the pair relationship. Apple is the better company and gains more COMPARED to AMT over time! That is a Hedge Fund Position for the novice.

Lets look at it further in more detail.

This means Apple only pays 26 times its value to match S&P500 Index, not 42 anymore. Now you start looking for a Stock that is underperforming the market for a short position. In this example we take American Tower Corporation (REIT).

It is not the best and I will look further, but it shows what we are looking for. AMT is going up on the right, BLUE line, which means from being 11 times in the S&P500 it is now 16 times in it, hence losing value to the market. A stock to potentially sell short. Thus, what looks APPL vs AMT now when we combine the divergence?

This is why Spread Trades, the essence of Hedge Funds, outperform the market over time all the time because the impact of the market is very much reduced or non existing.

Now we have that, but the single stock in the pair still moves with a different volatility against the market. To sort this out we have to calculate BETA, the statistical Regression. I have the Regression or BETA for AAPL already. Here comes AMT. This is simply done by EXCEL.

This 99.13% number I do not like and will look further since this stock I want to short should perform worse than 99%. I like about 70-80%!! I dont want it to be LIKE the market but to underperform the market by 20% so that it makes extra money, right? 

But we also see it is a total number game. No human emotions attached. Just simple math.

 

A 45 degrees angle is a market follower. But in our example we will add one more step to finish the hedge. Now we have different values of BETA and we need to balance them to be market neutral. We also have to put the different stock values and balance their weight!! Remember we make our money in the SPREAD! We hedge against the market! The divergence of the two stocks not their relation to the market! This is a hedged trade or a SPREAD TRADE!

We balance the trade that way that the combined BETA is market neutral, say 100% or 1. The market is always 1.

For this trade accordingly the amount of stocks for the long and short position are determined, deriving from the MAX Theme limit and position limit. Also consider that stocks have different prices. Pretty straight forward.

AMT has a BETA of 99,13% and AAPL of 112%. The result is that the LONG position is weighted with 46.95% and the SHORT position with 53.05%. This results in 99 shares for Apple for $11,869 and for AMT 59 shares and a total of $13,411. Thats it for the capital allocation.

Usually you go 5% per trade or per theme, or you double that, up to you. I go with 5% per theme and that is a spread trade position. A theme is a multiple of positions combined in one trade, a theme. There is a max limit of capital allocation. I chose 5%.

After we have all this the position runs its weekly check because we trade of the weekly charts for the most, Fridays is happy Hedge-Fund-Day and we update all potential and existing trades in our Wish Lists.
Now we have to determine the Stop Loss and also the ENTRY. Remember we do not play on standard charts, we create our own with EXCEL because we trade Spreads!

In the next image you see that the idea only might generate a gain of 2.55% over a 10 weeks period with an average gain of 0.26 per week. This is not great.

I usually go back for 10 weeks and determine within the next few weeks if the idea will actually become a trade.

This trade idea also seems to be very choppy. These are things we all filter out. There are better and more constant stocks, just find them and run them through the process. Check on your positions once a day or twice! Update all spread sheets on Saturday or on Friday after trading hours.

If we decide to take this trade there are two more hurdles to overcome before we enter. We have to determine the STOP LOSS and the SOFT PROFIT TARGET. We do this by calculating the ATR, the Average True Range of a stock. SL will be between 10-12, max 15% is cut off, there are better trades then!! The Target is 3 times SL, realistically sorted out!

The ATR for AMT is 7.8% and AAPL is 8.8%. So we combine the two and get our Stop Loss and Soft Target, Easy numbers, no? So we mark our SL and TRGT on the EXCEL graph since we cannot do this on most platforms. ALSO, the SL is to be kept in mind since most platforms dont have ratio SL of two assets. If the SL is hit we close BOTH Trades!!!

If we hit Soft Target we move SL and double the position since this trade is now WITHOUT downside and totally in the plus.

This is what I do all day long at the moment. Sorting out numbers and building up a Spread Trade portfolio. 

The most ridiculous investment in the stock market are people that trade with technical analysis only. I did this too. Now, I only use them including Candle stick pattern for determining the ENTRY ONLY!!! The most losing trades are mutual funds and Investment Banks since they only go long and that is super risky as we saw when COVID hit, the Black Swan event of 2020.

All information are publicly available. This trading approach makes you 100-200% a year!

But who am I to know that?

THIS IS BASICALLY WHAT A HEDGE FUND IS DOING. Just numbers.

Disclaimer:

None of the content published on https://hedgingstocks.blogspot.com constitutes a recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person. None of the information provided will advise you personally, concerning the nature, potential, value or suitability of any particular security, portfolio of securities, transaction, investment strategy or other matter.

Sources:

https://elite.finviz.com

https://elite.finviz.com/map.ashx?t=sec&st=w26

https://finance.yahoo.com/quote/AMT/financials?p=AMT

https://www.ismworld.org/supply-management-news-and-reports/reports/ism-report-on-business

https://www.questrade.com/home

https://fred.stlouisfed.org/series/GDPC1