In the past few years, hedge fund traders have inevitably become exposed to a global trading environment. The recent increase of correlation between assets that were previously thought to be impossible to connect has increased the intricacy of trading life. In conjunction, the speed at which hedge funds can close out arbitrage opportunities means the modern trading arena is more complex than ever before. In a crowded market with inconsistent levels of volatility, decision makers have been forced to think outside their proverbial box to ensure the production of alpha.

In a global space, positive market atmospheres like those we are currently witnessing make it even harder to place 'just in case' bets. For example, a strong rise in merger action throughout Asia brought the global M&A total to USD $193bn for Q1 of 2007, an increase from last year's Q1 USD $178bn (Forbes/TFN article) In such a market, it is often difficult and frustrating to be required to bet against the current trends. Furthermore, numerous people have attempted to call the top to this global run/fun and have so far been wrong; while traders have continued to enjoy a 'long' bull run in equities and commodities.

It is here that the responsible trader faces the difficult but important 'task' of hedging their book. Although hedges erode some profit from the trader's top line, and encourages the inevitable thought "if only I didn't have my hedges on…my P&L last month would have been even better", it is these traders that can sleep well at night and ensure capital preservation for their investors. However, eventually the aforementioned 'top-callers' will be right and there will be those who overstay their welcome in the market bull run and fall asleep at the wheel, damaging the fund and their P&L to different degrees. If and when a dramatic change in market conditions takes place, many traders will be forced to make drastic moves, but those that have maintained a balanced to slightly long-biased portfolio, with market hedges that have been negatively impacting, will only have to make slight adjustments to their style and mentality.

Hedging – from concept to implementation

In the simplest terms, a hedge is a contract or arrangement reducing one's exposure to risk. This seems clear enough, but the word 'risk' is a much more loaded and depends upon the eye of the beholder. There are numerous ways of describing risk:
 

1. A possible, usually negative, outcome.
2. The likelihood of a negative outcome.
3. The potential impact of an event, determined by combining the likelihood of the event occurring with the impact if it should occur.

Whichever meaning is most pertinent to you, each associates itself with weighing something positive versus something negative. Traders live, eat, and breathe this daily, but there are two types of trader when it comes to hedging, and this acts as another marker in the market. The first type of traders hedge their risk because they have to (due to management asking) while the second type of traders want to hedge their risk.

Going back to the example above; looking at today's current global bull run, it can be inferred that many traders are 'long only', meaning they have made good on their returns, but only because the market has been in their favour. What happens when true volatility returns and we get a solid bit of churn? The 'long only'/unhedged books will give back a considerable chunk of their winnings, while the hedged, balanced, books will hardly seem phased.

Having hedges on the book is a responsible thing to do (for the mental health of the trader as well as the well-being of your investors) and it doesn't have to be done strictly via placing a firm bet against the current trend. One can participate in the current market trend and still have hedges on the book without eliminating P&L opportunities or 'betting against the house'. A simpleexample of this would be to have a German Dax short versus a basket of long US equities. You can still return on the over-performance of the winning bull run on Wall Street, but protect yourself with a macro hedge that is indicative of an alternative equity market, if and when things get less bullish. While the current environment would be a losing bet for the DAX short, your bullish counterparts' returns would far outweigh your Dax losses. In keeping the same example, if and when things turn upside down, for whatever the reason, the losses in the same Wall Street longs are cut significantly by the short in the Dax, which, in this example, would shoot lower on a global correction and return alpha via the short stance/position.

In an ideal scenario, hedging your book's risk should be mandated from management and expected in each and every trader's book, but there is still a large global imbalance between those who are over and underexposed, which in itself creates trading arenas every day. Both the management and traders have the obligation to create returns for investors.

Therefore, being told to add hedges to your 'well performing and balanced (at least in your eyes) book' can be both frustrating and complicated. Having the foresight to hedge and accept the subsequent slight reduction in returns takes discipline. For the trader, limiting the downside on your book because of your hedges reduces the number of sleepless nights.

The bigger the market, the more obscure the risks

While at times, it may feel that your hedges are simply the lead apron to your alpha-creating success, they also force you to take a look at the bigger picture and realise that no market environment is long-term. Once focused purely on domestic markets, US hedge funds now have to adopt a wider perspective in order to continue to survive and thrive. In the past, risk management techniques involved looking at domestic markets, across a small number of asset classes. Now, as investments become more complex, risk management (especially from the trader's perspective) needs to take into account not only the geographical risks but also the structure of the investment, the underlyings and political factors. How will Nicholas Sarkozy being elected impact the hedge fund world? What if EUR/JPY hits 1.70? What if the US attacks Iran? If traders take the time to educate themselves on events that can potentially impact the global market, such as elections, market holidays and economic data, the trader will experience a natural urge and the tendency to hedge. Awareness of global events and local practices will allow traders to create a balanced, resilient book. Having traders on the ground in a number of regions and regular communication across the hedge fund offices ensures traders are alert to opportunities in the local and global trading markets.

With increases in multi-market understanding, innovation becomes a regular component of successful trading. This lessens the impact to your portfolio of not only a market shock, but also a change in trends. Constant monitoring of and conviction in your positions and trading format (which have ensured successful returns up to now), combined with the ability to innovate without forgetting your basic principals, is a formula for success. Without well thought out and well-placed hedges, the formula doesn't work. From the bare bones definition of 'reducing one's exposure to risk', to truly understanding the meaning of hedging and working within the parameters of your book, confidently and successfully using hedges is a comforting and essential element to trading in the global environment. Global bets are fundamental in an environment where it is not just the Dow and the dollar any more. Having hedges on the books lessens the impact of 'dramatic' events and even provides P&L in times where the majority of participants are scrambling to cover their losses. In the end, being a hedge fund trader is still a pressure-packed job, butthe amount of anxiety accompanied with it is purely correlated to the knowledge of the trader.

Nathaniel Orr-Depner monitors Lionhart's global currency risk and trades commodities as a hedge vehicle for the global book.