In fact, individual investors can benefit from studying these failures, since exactly the same factors that cause major hedge funds to fail also apply to retail investors.
How do hedge funds use leverage?
By definition, the only way that hedge funds can generate the high returns that their clients demand is to use leverage. One example of this is a currency carry trade. This is where a fund borrows money in one currency at a low interest rate, and then uses the money to buy another currency that has a higher interest rate. The return that they can make is essentially the difference between the two interest rates minus the cost of borrowing the money. Even when the spread between the two interest rates is relatively high, the return without leverage is rarely more than 3% to 4%.However, by using leverage, hedge funds easily double this return. However, no matter how good these trades look in principle, the sad fact is that they can and do go wrong. When this happens, the hedge fund can run into significant problems unless they have a proper risk management strategy in place. There are many different ways of managing risk, ranging from very simple to extremely complicated, but all of these strategies are designed to limit losses if the market behaves in a completely unexpected way.
What lessons can individual investors learn?
First of all, successful hedge funds know how to structure their positions so that they survive when the market exhibits unprecedented behavior. This is particularly important when it comes to margin calls – which are an unavoidable consequence of using leverage. A large number of hedge fund failures come about because they can’t meet these margin calls, resulting in them having to exit positions at the worst possible time.The second lesson is a direct consequence of the first one – always make sure you have enough reserves on hand to rescue any leveraged position. What this means is that it is fine to have part of your portfolio in highly leveraged positions, but make sure that your entire portfolio isn’t tied up in these – particularly if they are poorly diversified.
Finally, don’t get greedy. If you try to increase your takings too much through leverage, you will end up in serious trouble. Plan for all contingencies – including ones that you can’t predict – and make sure that your trades are set up so that you can survive the worst scenario. This may reduce your potential profits, but it will also ensure that you aren’t wiped out when things go wrong.
Editors’ Picks
EUR/USD holds gains near 1.0900 amid weaker US Dollar
![EUR/USD holds gains near 1.0900 amid weaker US Dollar](https://editorial.fxstreet.com/images/Markets/Currencies/Majors/EURUSD/MoneyEURUSD_3_XtraSmall.jpg)
EUR/USD defends gains below 1.0900 in the European session on Monday. The US Dollar weakens, as risk sentiment improves, supporting the pair. The focus remains on the US political updates and mid-tier US data for fresh trading impetus.
GBP/USD trades sideways above 1.2900 despite risk recovery
![GBP/USD trades sideways above 1.2900 despite risk recovery](https://editorial.fxstreet.com/images/Markets/Currencies/Majors/GBPUSD/british-banknotes-14144912_XtraSmall.jpg)
GBP/USD is keeping its range play intact above 1.2900 in the European session on Monday. The pair fails to take advantage of the recovery in risk sentiment and broad US Dollar weakness, as traders stay cautious ahead of key US event risks later this week.
Gold price remains on edge on firm prospects of Trump’s victory
![Gold price remains on edge on firm prospects of Trump’s victory](https://editorial.fxstreet.com/images/Markets/Commodities/Metals/Gold/stacks-of-gold-bars-19033163_XtraSmall.jpg)
Gold price exhibits uncertainty near key support of $2,400 in Monday’s European session. The precious metal remains on tenterhooks amid growing speculation that Donald Trump-led-Republicans will win the US presidential elections in November.
Solana could cross $200 if these three conditions are met
![Solana could cross $200 if these three conditions are met](https://editorial.fxstreet.com/images/Markets/Currencies/Cryptocurrencies/Solana/solana_XtraSmall.jpg)
Solana corrects lower at around $180 and halts its rally towards the psychologically important $200 level early on Monday. The Ethereum competitor has noted a consistent increase in the number of active and new addresses in its network throughout July.
Election volatility and tech earnings take centre stage
![Election volatility and tech earnings take centre stage](https://editorial.fxstreet.com/images/TechnicalAnalysis/Volatility/Bands%20(bollinger)/stock-market-graph-gm532464153-55981218_XtraSmall.jpg)
The US Dollar managed to end the week higher as Trump Trades ensued. Safe-havens CHF and JPY were also higher while activity currencies such as NOK and NZD underperformed.
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