Hedge funds

Hedge funds are a type of leveraged fund, which refers to any number of different forms of speculative asset management funds that borrow money for speculation based on real assets under management. For instance, a hedge fund with $100 million under management can leverage those assets (through margin agreements with their trading counterparties) to give them trading limits of anywhere from $500 million to $2 billion. Hedge funds are subject to the same type of margin requirements as you or we are, just with a whole lot more zeroes involved.

The other main type of leveraged fund is known as a Commodity Trading Advisor (CTA). A CTA is principally active in the futures markets. But because the forex market operates around the clock, CTAs frequently trade spot FX as well.

The major difference between the two types of leveraged funds comes down to regulation and oversight. CTAs are regulated by the Commodity Futures Trading Commission (CFTC), the same governmental body that regulates retail FX firms.

As a result, CTAs are subject to a raft of regulatory and reporting requirements. Hedge funds, on the other hand, remain largely unregulated. What important is that they all pursue similarly aggressive trading strategies in the forex market, treating currencies as a separate asset class, like stock or commodities.

In 1990, there were about 100 hedge funds with about $40 billion in assets under management. That industry has absolutely exploded in the last few years. Today, there are over 10,000 hedge funds managing over $1.5 trillion in assets. How’s that for a growth industry?

In the forex market, leveraged funds can hold positions anywhere from a few hours to days or weeks. When you hear that leveraged names are buying or selling, it’s an indication of short-term speculative interest that can provide clues as to where prices are going in the near future.

Speculating with black boxes, models, and systems

Many leveraged funds have opted for a quantitative approach to trading financial markets. A quantitative approach is one that uses mathematical formulas and models to come up with buy and sell decisions. The black box refers to the proprietary quantitative formula used to generate the trading decisions. Data goes in, trading signals come out, and what’s inside the black box, no one knows. Black box funds are also referred to as models or system-based funds.

Some models are based on complex statistical relationships between various currencies, commodities, and fixed income securities. Others are based on macroeconomic data, such as relative growth rates, inflation rates, and geopolitical risks. Still others are based on technical indicators and price studies of the underlying currency pair. These are frequently referred to as rules-based trading systems, because the system will employ defined rules to enter and exit trades.

If you’re technically or statistically inclined, you can create your own model or rules-based trading system. Many online trading platforms offer Application Programming interface (API) access to their trading platforms, allowing you to draw price data from the platform, filter it through your trading system, and generate trading signals. Some even allow for automated trade execution without any further user action. Check with your online currency brokerage firm  to see if it has an API and supports automated trade executions. 

Trading with discretion

The opposite of a black box trading system is a discretionary trading fund. The discretion, in this case, refers to the fund manager’s judgment and overall market view. The fund manager may follow a technical or system-based approach but prefer to have a human make the final decision on whether a trade is initiated. A more refined version of this approach accepts the trade signals but leaves the execution up to the discretionary fund managers trading staff, which tries to maximize position entry/exit based on short-term market dynamics.

Still another variation of discretionary funds is those that base their trading strategies on macroeconomic and political analysis, known as global-macro funds. This type of discretionary fund manager is typically playing with a longer-time horizon in mind. The fund may be betting on a peak in the interest rate cycle or the prospect that an economy will slip into recession. Shorter-term variations on this theme may take positions based on a specific event risk, such as the outcome of the next central bank meeting or national election.