Handbook of Hedge Funds

5

Understanding the Tools Used by Hedge Funds

Give me a lever long enough and a place to stand and I will move the world

Archimedes

Before going into detail about the various hedge fund strategies, we believe that it is useful to introduce the basic tools used by hedge funds to implement their trades, namely, buying, selling, short selling, buying on margin, using derivatives and leveraging. Several of these tools are not used in the traditional investment world, which explains why people often have trouble understanding them, or perceive them to be extremely complicated and/or purely speculative. In this chapter, we will therefore cover the basic mechanics and rationale of each of these tools and provide a good understanding of the subject-matter.

5.1 BUYING AND SELLING USING A CASH ACCOUNT

The key to successful investing – buy low and sell high – is one of the oldest pieces of investment advice on record. It sounds so simple that one could hardly argue with it. In terms of operations, the strategy involves two basic transactions, buying long and selling at a later date, hopefully at a higher price. Its profit simply equals the difference between the sale price and the purchase price.

Buying long is the most common strategy, at least from an individual investor’s perspective. A hedge fund buying long has some cash and simply exchanges it for the security that it wants to hold. In a sense, the transaction can be represented as a swap (see Figure 5.1). Once the transaction ...