HOW TO TRADE LIKE A HEDGE FUND MANAGER
This is how to trade like a hedge fund manager is really about
the steps to developing a successful trading strategy. Having worked
with many money managers and being involved in the process of
launching managed fund products, I have realized that all money managers
work in a similar way. Their strategies may be different, but the way they
come about developing these strategies is not. The reason there are common threads is because professional fund managers need to have accountability. In other words, they need to understand their own methodology
inside and out.
The difference between a professional and an unprofessional trader is
that a professional never goes into a trade blindly. This is important because in order for professional money managers to be confident enough to
solicit investments into their funds, not only do they need to have a battletested strategy, but they also need to know when the fund succeeds, when
it fails, and how bad things can get.
As retail or individual traders, our $20,000 accounts are just as important as any $20 million hedge fund. In fact, our accounts may be even
more important, because we are trading with our own money whereas the
$20 million hedge fund manager is most likely trading with other people’s
money. Therefore, if all hedge fund managers follow a five-step process
in developing their trading strategies, there is no reason why individual
traders should not to do so as well.
The best way to develop a trading strategy is to follow a five-step topdown approach:
- Properly defining the trading strategy.
- The art of entering and exiting.
- Test drive.
- Getting intimate.
- Self-reflection.
PROPERLY DEFINING THE
TRADING STRATEGY
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Every hedge fund manager, like every trader, follows a different methodology. Some will only use fundamental analysis, while others will only use
technical analysis. The first thing to do is to figure out what type of trader
you are and what type of style you want to trade in. This chapter will not
tell you which style of trading (fundamental versus technical or short-term
versus long-term) will be the most profitable, because there isn’t one style
that is best. In Millionaire Traders: How Everyday People Beat Wall Street
at Its Own Game (John Wiley & Sons, 2007), we interviewed 12 successful
traders from all walks of life and learned that there isn’t just one way to
trading success. Every trader is different; some would hold positions for
weeks and months, while others would hold them for mere seconds.
There are four key things that you need to think about when defining a
strategy, and these need to be done before you start trading. Trade with a
plan and do not develop that plan on the fly.
Fundamental or Technical?
The first step to defining a trading strategy is to figure out whether you
want to trade based on fundamentals or technicals, or a combination of
both. When fund managers develop systematic trading strategies, clear-cut
rules are developed so that they can be coded. Although not everyone will
be coding their trading strategies, there is a lesson to be learned from that
process, as one of the primary reasons traders fail is because they get too
emotional. Coming up with your own rules is extremely important, because
following rules takes the emotion out of trading. Figuring out whether you
want to base your trades on news or a technical indicator is only the initial
step to defining your trading strategy.
What Currencies Will You Trade?
The second step is to determine which currency pairs you want to trade,
because not all currencies are created equal. In FX, there are generally two types of trading strategies—trend following or range trading. Most
hedge funds are trend following because of the one-way directional bias
of the currency market, but many people are contrarians by nature and
may choose to range trade instead. There is no wrong or right choice, but
in order to increase the probability of success, many hedge fund managers
will narrow the currency pairs that the system will trade. Rarely have I seen
professional traders apply the same strategy to every single currency pair.
They will almost always have currency pairs that they trade often and currency pairs that they never trade. For example, if your trading strategy calls
for a risk of no more than 100 pips on each trade, currency pairs with wide
ranges like the GBP/JPY and the EUR/CAD should be avoided and probably
not traded, because even if the currency pair eventually moves in your desired direction, its wide swings may stop you out before doing so. Another
example would be to apply range-trading strategies only to range-trading
currency pairs and apply trending strategies to trending currency pairs.
The CHF/JPY, for example, is a great currency pair for a range-trading strategy and a horrible one for a trend-trading strategy, because except for one
spike lower, it has been trapped in a 300-pip range from September 2007 to
March 2008. Therefore, a person with a range-trading strategy should look
to trade only currency pairs like the CHF/JPY, while trend traders should
avoid the CHF/JPY at all costs.
When it comes to currencies, another thing to consider is majors versus crosses. Major currency pairs such as the EUR/USD or the USD/JPY
tend to be very sensitive to what is happening in the U.S. dollar, whereas
this is generally not the case for the crosses, because they do not include
the U.S. dollar. News traders may find this tip particularly useful, because
unless you are trading U.S. data, crosses could actually be better bets because their price action may be less distorted by the market’s appetite for
U.S. dollars.
What Time Frame Will You Trade?
The third step to defining your trading strategy is to determine what time
frame you want to trade. A strategy that works on a daily chart will probably have far less accuracy on a 5-minute chart. For example, if you are
using the inside day strategy, you will see that inside days are far more
common on intraday charts and far less common on daily charts. This is
why they are extremely accurate when they do appear on daily charts; the
rarest things can be the most valuable.
Finally, when it comes to time frames, other things that need to be
considered include whether you will hold positions overnight and over the
weekend. For example, short-term traders may find it more profitable to
close their trades if they are not working after a certain number of hours or when the market switches into the Asian trading session. This would apply for traders reacting to news, because if the trade does not move in your
favor after a few hours, the momentum from the news release has probably waned. As for the weekend, occasionally something big may happen
between Friday night and Sunday afternoon. Unless you have stops that
can absorb any shocks or you know that there isn’t a significant event risk,
closing positions before the weekend may also be something to consider.
THE ART OF ENTERING AND EXITING
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In an interview for Millionaire Traders: How Everyday People Beat Wall
Street at Its Own Game, Rob Booker made a fantastic analogy. We were
talking about whether the entry of a trade or the exit is more important, and
Rob likened this to flying and asking a pilot which is more important, the
takeoff or the landing. Without even needing to ask a pilot, as passengers,
we will all agree that the same degree of precision needs to be applied to
both the takeoff and the landing. This is true for trading as well.
The majority of traders spend their time trying to figure out the best
entry strategies by looking for the perfect combination of indicators for
buy and sell signals, while their exit strategies are usually relegated to being nothing more than an afterthought. Yet this afterthought often is what
differentiates consistently profitable traders from ones who are perpetually looking for a better trading strategy. Too often have I heard traders
complain about how they let a winning trade become a losing one.
When hedge fund managers design trading strategies, they give a great
deal of thought to both entries and exits. There are primarily four different
ways to enter or exit a trade:
- Single entry, single exit: With a single entry and a single exit, traders basically put on their entire position at one price and exit the entire position at one price.
- Single entry, multiple exits: With a single entry and multiple exits, traders enter their entire position at one price but scale out of the position at different prices. This tactic is usually used to ride a breakout or trend for as long as possible while banking some profits along the way.
- Multiple entries, single exit: With multiple entries and a single exit, traders scale into a position at different prices but end up closing the entire position at one price. This tactic is used by traders who are averaging down and averaging up. To average down means to add to a position as it moves against you with the hope of attaining a better average price. To average up means to add to a position as it moves in your favor.
- Multiple entries, multiple exits: With multiple entries and multiple exits, traders scale both into and out of their positions. This is a tactic frequently used by trend traders. They average up into a position by adding to winning trades and scale out of the position to capitalize on as much of the trend as possible.
With automatic systems, entry and exit strategies are set in stone and
coded into the system. Traders should try to approach entries and exits in
the same way by deciding which of the four combinations to use before
laying on a trade. For those traders who like to average up or down, an
important question to ask is how low or how high you are willing to buy. If
you keep on adding to a losing trade, at some point it just becomes smarter
to bite the bullet, take the loss, and admit that the move you were initially
looking for will not happen or the trend has changed. A good rule of thumb
is to average down no more than three times. When it comes to stops, there
should be no art involved—have a set rule on placing stops and stick to it.
TEST DRIVE
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You will never buy a car without test-driving it, so you should never trade
a strategy without back-testing it! For hedge funds and developers of automated trading systems, back-testing is extremely important because if
a trading strategy did not make money in the past, how can they believe
that the strategy will make money in the future? Many FX traders will learn
strategies from their friends, trading coaches, or even this book, but no one
should ever just follow a strategy blindly. Make sure it is back-tested and
forward-tested.
For traders who are particularly good at programming, code your strategy using something like TradeStation, eSignal, or Meta Trader, run the
results, and make sure that it is profitable.
Traders who do not know how to code should do the visual back
test. Open your charts, apply your indicators, and look for a minimum of
20 examples of the strategy working. Then downgrade the time frame of
your charts to make sure that the strategy could have been executed at
your desired price. For example, if you are trading a strategy based on
hourly charts, make sure there are no spikes on the 5-minute charts.
Once you have found your back-tested examples, it is time to forwardtest. One of the great things about trading currencies is the wide availability
of demo and mini accounts. It is important to live test with a small amount of money, because once there is actual money involved, a whole different set of emotions will arise, and controlling those emotions is an important part of developing the discipline you need to trade larger amounts of
money. The best thing to do is to focus on the changes in pips and not the
changes in dollars.
GETTING INTIMATE
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The fourth step to thinking like a hedge fund manager is to get intimate
with your trading strategy, because not all trading strategies are alike.
Understanding Performance
When it comes to performance, there are two primary types of trading
strategies—one that has a high percentage of profitable trades and one that
has a high profit factor.
In strategies that have a high percentage of profitable trades, usually
the amount of pips made in winning trades is approximately the same as
the amount of pips lost in losing trades. An example would be a strategy
where 8 out 10 trades are winners, with each winning trade making 20 pips
and each unprofitable trade losing 20 pips. Although this does not satisfy
the textbook description of a good risk-to-reward ratio, if the number of
profitable trades is far higher than the number of losing trades, the strategy
is still a solid one. In the previous example, the net profit for the 10 trades
would still be 120 pips. Therefore, if you have a strategy similar to this and
it starts to have six or seven consecutive losers, you know that it is time to
seriously reexamine the strategy.
For strategies that have a high profit factor but a low percentage of
profitable trades, having a string of losers may be a part of the trading
strategy. This applies particularly to breakout traders who may take small
positions with tight stops in anticipation of a big breakout. Although they
may get stopped out often for 30 or 40 pips, when the breakout occurs, the
eventual move could be to the degree of 400 or 500 pips.
The key here is to know exactly what type of market environment your
strategy performs well in and what type of market environment your strategy fails in, because only then will you know when it is time to pull the plug.
Understanding Drawdown
In the currency market, managing losses is extremely important. Many people who are new to the currency market argue that trading FX is far more
dangerous than trading any other asset. In some ways they are wrong and in some ways they are right. With only eight major currencies to trade, the
FX market is much easier to understand than other markets. Also, since
most people trade only the G-10 currencies, economic data cannot really
be manipulated and there will almost never be a scenario like WorldCom
or Enron. On a day-to-day basis, currency rates usually move no more than
1 to 2 percent, which actually makes them one of the least volatile assets
to invest or trade in. However, the availability of very high leverage does
make trading currencies more dangerous. Some brokers offer as much as
400-to-1 leverage, which makes a 1 percent move more like 400 percent. It
therefore becomes much easier to blow up your trading account. Thankfully, leverage is customizable, and it is important for traders to actively
manage their risk.
Understanding the drawdown of your trading strategy helps to manage risk by giving you a frame of reference for determining when to pull
the plug and when to sit tight. A drawdown is defined as the reduction
in account equity from a trade or series of trades. All professional money
managers know the maximum drawdowns of their trading strategies. For
example, I once tested a strategy involving carry trades, and the maximum
drawdown for the strategy over the past 10 years was 15 percent. With that
number in mind, I knew that if the drawdown going forward hits 10 percent, it does not necessarily mean that the strategy has failed. However,
if the drawdown hits 15 percent I should start getting very worried; and if
it hits 20 percent, then I know that this may be a completely new trading
environment not previously accounted for in the back test, and for that reason, it may be time to seriously consider pulling the plug, admitting that I
am wrong, and terminating the strategy.
When it comes to drawdowns, there are three main things that all
traders need to know about their strategies. The first is the average drawdown on a given trade; this is important because it lets you know whether
the trade is behaving in accordance with your strategy. The second is the
degree of the biggest drawdown; this lets you know how bad it can get.
Finally, you need to know whether the drawdown is on a closing or an
intratrade basis. Oftentimes the drawdown or maximum loss on a closed
trade may be different from the drawdown or floating loss on an open
trade.
SELF-REFLECTION
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The last step of thinking or trading like a hedge fund manager is selfreflection. A few years ago, after I conducted an FX trading workshop in
Malaysia, a trader came to me for advice. He told me that he had a trading
strategy that worked well in nearly all market environments except when news was being released. Interestingly enough, he asked me what I thought
he should do, and I simply said, “Don’t trade when news is being released!”
Oftentimes we become so absorbed with trading that we do not notice
the obvious. This why it is important to spend some time on a weekly or
monthly basis to go over or reflect on your trading. At the end of every
week, Boris Schlossberg, with whom I run BKTraderFX, and I will sit down
and go over each and every one of our trades. We will ask ourselves why
a particular trade worked, why it did not work, and what we could have
done better. We will review both the winning and losing trades to look to
find room for improvement. In fact, with every trade that we take, we will
ask ourselves if this is in line with our trading strategy, and if not, will
we end up regretting making the same mistakes at our end-of-week review
sessions.
For the trader in Malaysia, the small improvement that he needed to
make may have simply involved avoiding news releases, which can be applicable for range traders in general. Other people may realize that they are
taking profits too early or find that their performance improves by limiting
their trading to certain times of the day. Small and simple changes such as
these can make a long-term difference for all traders.
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