I’ve been telling you for weeks that hedge funds have been sucking wind, partly due to too often plowing into the same trades then exiting them too late.
But I’ve also been telling you that they’re ready for a comeback…
And the election of Donald Trump just proved it. You see, many hedge funds actually played the election close to perfection.
Whether they’re able to continue their recent burst of positive performance doesn’t matter to us, unless of course you’re in any of those floundering funds.
What matters to us is what positions they’re into now and when they’ll unwind them.
Because knowing what we know about their positions we can front-run their exiting strategies by putting on smart risk/reward reversal trades.
How Hedge Funds Won Big on Trump’s Victory
Before the election hedge funds got “long” (meaning they bought) the S&P 500 by buying S&P 500 futures, got long copper by buying copper futures, and shorted (bet prices would fall and yields would rise) U.S. Treasury bonds by selling bonds short.
Going into the election, per ValueWalk, hedge funds were long equity futures, “Not just a little long. But positive on the market to the tune of $24 billion in the S&P 500 futures from October 25 to November 8 – the largest hedge fund long position since the last mid-term elections when Republicans made gains in Congress.”
That analysis from ValueWalk came from a Bank of America Merrill Lynch report authored by the global market analysis team of Jue Xiong, Stephen Suttmeier, and Paul Ciana, who calculated the net long position in the futures by culling Commitment of Traders data from the Commodity Futures Trading Commission.
To hedge their long S&P 500 exposure, some funds shorted tech stocks based on how much they’d already run-up and that Mr. Trump’s campaign rhetoric would result in reduced “globalization,” knocking tech darlings in the process.
When Trump won, after an immediate freakout that tanked futures on very thin volume (fueled by some panicked selling by long-positioned funds). But then, to the great relief of long-positioned traders, selling dried up and buyers reversed futures losses by the time U.S. equity markets opened on Wednesday morning.
With the panic apparently over, traders who took on big short positions in anticipation of a selloff if Mr. Trump won scrambled to cover their shorts.
Very quickly, sidelined institutions – who had reduced their longs and hedged some of their remaining long equity exposure by shorting $3.3 billion worth of S&P 500 futures – covered their short futures trades and began to buy back shares they’d dumped and even bought futures to get longer in front of unexpectedly rising indexes.
Lots of hedge funds nailed the action. The S&P 500 soared and tech stocks tanked.
Besides going long equities, hedge funds shorted Treasury bonds, betting a Trump victory – with its big infrastructure spending plans and a debt ceiling vote coming up in March – would put huge upwards pressure on interest rates, even before the Fed would have to raise in December, and crush bond prices.
Fund managers who shed Treasuries, resulting in outflows of $11.5 billion in the two-year note and $1.3 billion in the ten-year note, continue to reap rewards for betting correctly that bond prices would fall precipitously.
Many CTA and CPO (managed futures) funds put on another type of hedge fund trade intended to make money if Mr. Trump won: a bet that a spike in copper prices would accompany his trillion-dollar infrastructure promises.
By November 8, CTAs and CPOs had increased their net long positions in copper by 25.3%. That futures buying moved copper past certain standard deviation-based trading range parameters, attracting more momentum buyers.
Hedge funds got that bet right big-time. When Mr. Trump won, copper prices soared.
Now that the quick money’s been made, at least on paper, lots of traders are going to want to close out their successful trades to book profits, which they desperately need.
With market-moving “Trump Trades” already a week old, a lot of traders are sitting with their fingers on the sell button, ready to lock in their profits if more somber assessments of Mr. Trump’s prospects of fulfilling his campaign promises get muted in political realities.
That’s where we come in.
How to Profit from the Hedge Funds’ Next Move
By putting on “reversal trades” that anticipate hedge funds exiting moves out of their profitable trades in the S&P 500, bonds and copper, we can effectively front-run their march to the exit doors.
While I personally think equities can go a lot higher in the long run, it makes sense to put on a short-term downside play to try and front-run hedge funds selling their long S&P 500 futures positions to book their profits.
You can do that cheaply by buying near-term (expiring within a month or two) puts on S&P 500 based ETFs, like the SPDR S&P 500 ETF (NYSEArca:SPY).
Since tech stocks have been pummeled by short sellers, and then by long holders selling positions as support levels have been broken, it makes sense. Especially if markets flatten out and trade sideways here for a while (as they were before the election rally), or continue higher, to buy the most beaten-down big tech stocks.
You can do that by buying the big names that have been under pressure, especially the ones that are now at new support levels, or by buying short-term call options on them to catch any quick upward pops as traders cover their shorts and institutions get back into them or average down now that they look “cheap” relative to stocks that just soared.
And, as the build-up to Mr. Trump’s infrastructure spending gets revisited in the face of rising rates and political and deficit realities, the shine can quickly come off the long copper trade.
In anticipation of traders exiting their profitable copper trades, it also makes sense to short overbought copper ahead of fiscal realities.
One of the things that futures traders look for is “open interest” or how many open futures contracts are outstanding. If open interest in copper futures doesn’t increase from here – and it hasn’t – traders will see that as a sign of waning long interest and start to take their profits.
That’s another opportunity to front-run traders looking to reverse their recent longs.
Besides putting on a short copper futures trade, which I only recommend for proficient and seasoned futures traders, buying near-term (one to three months out) put options on some of the recently highflying copper-related stocks or miners, is a worthwhile bet.
We’re always looking at what hedge funds do in my newsletters, and while we’ll sometimes make similar trades to them, sometimes we’ll front-run them out of positions they’ve amassed before they head for the exit doors at the same time.
And that’s just what we’re doing today. Because as I’ve been telling you, understanding how hedge funds make money – and how they blow it – can be great for your own trading prospects.