Do hedge funds use stop-loss is a question that often people ask. Hedge funds are quite popular for making a lot of money. How do they make it? How do they manage risk? It is a mystery. However, if you want to know if hedge funds use stop-loss to manage risk, then you are on the right platform.
In this article, we are going to discuss whether or not hedge funds use stop-loss. Let’s dive deep to find out.
Do hedge funds use stop-loss?
Stop-loss order is a very important risk management tool for individual traders. It enables them to exit their trades if they go wrong. However, it is not clear whether hedge funds use stop-loss in trading. The answer to this question is a simple and straightforward one. That is because hedge fund operations are complicated and large-scale as compared to retail traders. So, do hedge funds use stop-loss or they don’t?
In simplest terms, some hedge funds use stop-loss as a risk management tool. However, their proportion is low as compared to those who don’t use stop-loss. This is the information that surfaced in 2014’s Hedge Fund Journal report. It stated that most hedge funds didn’t use stop-loss. In fact, the journal indicated that around 20% of hedge funds use stop-loss.
Most hedge fund managers believe that stop-loss orders cause increased transaction costs. They also believe that stop-loss orders often get you out of desirable positions. So, you know now some hedge funds use stop-loss for risk management while some don’t. Now, let’s see how hedge funds use stop-loss.
How do hedge funds use stop-loss?
There are two major types of hedge fund operations. Some hedge funds use quantitative strategies. Their strategies are based on mathematical and statistical analysis. On the other hand, fundamental hedge funds don’t solely rely on quantitative analysis. They also value human intuition. Among these two types, quant funds generally use stop-loss while fundamental hedge funds don’t.
Now, let’s head back to our question: how do hedge funds use stop-loss? There are many ways hedge funds may use to place stop-loss orders. However, two ways are more common. Firstly, some hedge funds use strict stop-losses. These stop-loss orders get them out of position as soon as the price hits them. Secondly, some hedge funds use tiered monitoring which involves constant tracking of position. They immediately re-evaluate their position when a stop-loss is hit. In other words, they don’t sell their assets when a stop-loss order is triggered.
Again, you might be wondering why some hedge funds use stop-loss while others don’t. The answer is simple. Stop-loss orders have numerous advantages but at the same time, it also has certain disadvantages. That’s why some hedge funds use stop-loss while others don’t. Let’s discuss now why hedge funds use stop-loss.
Reasons why do some hedge funds set stop-loss orders
As you know, stop-losses are generally considered among the best risk management techniques. Hedge funds also need risk management techniques and that’s why some hedge funds use them. The fact that some hedge funds don’t use stop-loss doesn’t necessarily mean that it doesn’t work. It works and it helps in managing loss. In fact, stop-loss orders help in minimizing losses as well as book profits.
Now, can we imagine that hedge funds cannot make a wrong decision? Yes, they can make a wrong decision because they don’t have divine powers to make the right decisions always. They can make a bad decision and for that, they need the stop-loss to cut losses short. A stop-loss order enables them to cut losses short and jump back in later on.
Let’s try to understand it through an example. Suppose that a hedge fund’s analysts make a wrong decision based on a misjudgement of the market trends. Should they use the stop-loss to cut losses short? Yes, they should and they do to enter the trade when prices become favorable.
Why don’t hedge funds use stop-loss?
On the flip side, the majority of hedge funds don’t use stop-loss. They have their own reasons for not using stop-losses. The first major reason is stop-loss orders increase transaction costs. Secondly, stop-loss orders may get them out of a desirable trading position. How so? Let’s try to understand it through an example.
Suppose that a hedge fund is betting on some undervalued stocks and entering its position. What will happen if the prices of those stocks get further lower before bouncing back? They will trigger stop-loss orders and get the hedge fund out of the favorable position. So, we can say that stop-loss will prove very costly for the hedge fund in this scenario. On the other hand, if they don’t set a stop-loss, they won’t get out of a favorable position. That’s why some hedge funds may decide against using stop-losses.
Secondly, let’s see how stop-losses lead to increased transaction costs. As you know, when stop-loss orders get triggered, sell orders are placed and that accompanies transaction costs. So, we can say that stop-loss orders getting triggered frequently increase transaction costs. The situation becomes even worse when hedge funds operate in more volatile markets. Prices fluctuate greatly in volatile markets and therefore, may trigger stop-loss unnecessarily.
Some hedge funds use stop-loss whereas many others don’t. Hedge funds using stop-losses base their decision on their strategy. They consider stop-loss a good device to cut losses short. On the flip side, there are hedge funds that don’t use stop-loss. They have their own reasons and rightly so. In short, whether hedge funds use stop-loss or not, depends on their trading strategy. Furthermore, they may also decide to use stop-loss on the basis of the liquidity of the market they trade-in.