Hedge Fund Secrets of the Masters

Nicholas Vardy

Nicholas Vardy has a unique background that has proven his knack for making money in different markets around the world.

“In real estate, the key is location, location, location. With money management, the key is risk control, risk control, risk control.”

Bruce Kovner, founder of Caxton Associates, one of the most successful hedge funds of all time

In this special report, I will share with you secrets of how to maximize your profits as a subscriber to The Alpha Investor Letter.

Today’s global investment arena is as challenging as it’s ever been.

But imagine if you had access to a technique that would allow you to gain complete control over your trading and investing. While your friends are glued to CNBC, entranced by the relentless onslaught of the latest negative news from Wall Street, picture yourself standing above the fray — completely in control of your financial destiny. Unlike other shell-shocked investors, you can feel secure in the knowledge that your hard-earned dollars never will suffer from the kind of financial meltdown you’d endure by following mainstream investment advice.

The technique I’m about to share with you provided the basis for a system that I developed to manage a top-performing hedge fund during the post dot-com bust in 2001 and 2002. The result? While other hedge funds struggled as they dropped 30%, 40%, even 50% in a grueling bear market, we used what I am about to teach you to preserve our capital and were uniquely well positioned for the inevitable bull market that followed. This technique also has served as the basis for my popular seminar, “Hedge Fund Secrets Revealed: How to Become Your Own Hedge Fund Manager.” I regularly present the seminar at the MoneyShows (www.MoneyShow.com) held periodically throughout the year.

In order to benefit from the system in this special report, here’s what you need to do:

  • Realize that what you are about to learn represents a fundamentally different way of looking at investments. Don’t expect your broker or financial planner to know about or to understand this approach. So please keep an open mind.
  • Understand that this is about managing your risk — and not about promising pie-in-the-sky results. The very best of the top hedge fund managers have a tough time in bear markets. Like life, markets have their seasons. Once you have these principles down, the upside will take care of itself.
  • Try implementing the techniques that I outline in this special report on my Alpha Investor Letter for 90 days. I’m sure that it’ll not only change your thinking about how you invest in stocks forever, but you’ll also be a lot richer for it.

So let’s get started with a question:

What is the ONE (and probably the ONLY) question you ask when you look at an investment recommendation?

You have three choices:

  • What Do I Buy? (Entry)
  • When Do I Sell? (Exit)
  • How Much Do I Buy? (Position Sizing)

If you’re like 99%+ of investors, you want to know the “hot stock tip” — in other words:

“What to buy.”

I’m about to reveal to you something that even some of the VERY TOP hedge fund managers in the world don’t realize:

What you BUY is A LOT less important than when to SELL. And when to SELL is less important than HOW MUCH you buy.

According to trading coach Van Tharp, the relative importance of these three decisions is as follows:

Entry 10%
Exit 30%
Position Sizing 60%

Let’s look at each of these in order of importance:

I. Entry — “Not the ‘Holy Grail’”

Although we haven’t actually met, here’s something I already know about you…

The reason you subscribed to Alpha Investor Letter was that you wanted the latest, greatest and most profitable ideas out there. You wanted an investment newsletter that offered you the top stock tips. You wanted the “Holy Grail” — and you were hoping that I’d be able to provide it.

And you’ve come to the right place. Based in the heart of London’s hedge fund community, I analyze U.S. and foreign stocks, commodities and currencies, and I recommend those that I think are the top investment opportunities — no matter where they are on the planet. As a subscriber to Alpha Investor Letter, you’ll learn about investment opportunities you simply haven’t heard of anywhere else.

But I’ll let you in on a secret. And it’s one that you already probably know — but this is probably the first time you’ve had it pointed out to you.

As important and as valuable as each individual stock pick is, it can be pretty darn near useless unless you have a disciplined framework for investing. A scattershot approach is not the way to achieve long-term investment success. In fact, trading psychologists have shown that if you don’t have a disciplined plan for managing your stock picks, you can actually lose money even if you invest in nothing but the world’s top-performing stocks.

How is this possible?

Just think for a minute… Have you ever bought a stock which turned out to be a big winner, only to see it drop? But you held on, hoping that it would bounce, and resume its upward trend? Then what happened? The stock collapsed and you still held on — rationalizing that it was “too late to sell.”

Well, if you’ve had this happen to you, you already know that unless you have a plan in place to manage each and every one of your stock picks, there are many, many things that can keep you from locking in big gains.

I can send you 10 consecutive winners in Alpha Investor Letter. But unless you know what you’re doing, you can lose money on each and every one of them.

As an Alpha Investor Letter subscriber, I don’t want that to happen to you. And that’s the purpose of this Special Report. 

II. Exit ‘Don’t Run the Red Light…’

With each Alpha Investor Letter pick, I also provide you with a “stop” (or exit) price. You ignore these stop prices at your own peril.

You’ll be surprised to learn that those stop prices are three times as important as your picks — if you know how to use them.

And sticking to your stop will put you ahead of EVERY SINGLE mutual fund manager out there… BY LAW.

Think of it this way…

Imagine that your neighbor has a teenage son who is a reckless driver…

As testosterone charged as he is, he regularly speeds through red lights…

But because he’s never been in an accident, he thinks he can get away with anything…

Then one day, he speeds into an intersection, gets hit by truck and WHAM! Result?

A totaled car… and (if he’s lucky) a seriously chastened teenager…

So think of ignoring your stops as a lot like going through a red light…

…You can ignore your stops… and you may even get away with it a few times… but at some point, you ARE going to get hit by the equivalent of a Mack truck.

As long as you keep investing and trading, it’s not a question of IF, but WHEN.

So why will following this single rule make you better than the best mutual fund manager out there?

As a former mutual fund manager myself, I can tell you that your mutual fund manager is actually breaking the law if he is not fully invested in the stock markets — even if the stock market is headed straight down for the next 10 years!

You, on the other hand, don’t have your hands tied like this. You can SELL anytime you want.

By determining your stop price at the same time you buy your stock, you KNOW your worst-case scenario EVEN BEFORE YOU GET IN THE MARKET.

It’s really common sense…

But as Voltaire said:

“Common sense is not so common”…

III. Position Sizing: The Secret That Accounts for 60% of Your Trading Success

Ask any hedge fund manager who has been around for more than a few years about the most important thing in his trading… and he will tell you it is position or bet size…

If he gives you a different answer, don’t even THINK about giving him your money. He and his investors are bankrupt already. He just doesn’t know it yet…

Let me illustrate the importance of bet size with this example…

It’s early September 2008. Let’s say that you’ve decided to call the bottom of the meltdown in U.S. financial stocks. You’ve just heard your favorite analyst on CNBC talk about how financial stocks are due for a bounce. In fact, you even heard that hedge fund guru George Soros has placed a large bet on Lehman Brothers’ recovery. You’ve decided it’s time to bet on a big turnaround. It’s as close to a “sure thing” as you’ve seen.

You have $50,000 to invest, and you decide that this is a once-in-a-lifetime opportunity to hit it big. You decide to “bet the farm.”

So you buy $50,000 worth of Lehman Brothers stock…

At the time you placed your bet, one of two things can happen:

One, your bet works out, and you make five times your money. You think you are a genius — and calculate that you only need to do this six more times to become a billionaire… (Do the math yourself…)

Or two, the minute you buy the stock, Lehman Brothers starts plummeting on rumors of an imminent collapse. And because you bet all your money on Lehman Brothers, you spend your days glued to your computer watching every tick in Lehman’s stock price. Every drop in Lehman’s price is PAINFUL… and is reducing your net worth considerably…

After a weekend wracked with worry, on Monday morning, Sept. 15, you hear the news that Lehman Brothers went bankrupt.

You’ve lost everything. You made a novice’s mistake and bet much too big on one idea.

That idea didn’t work out, and you are literally blown out of the game.

Contrast this high-stress image of you with your new “enlightened” self once you understand the risk-management technique I’m about to give you below.

Let’s say you’re willing to place a bet that Lehman Brothers is going to make it…

But now that you understand the importance of exits and position sizing, the scenario is very different.

You know that as smart as you know you are, you are not infallible.

And even if you do consider yourself infallible, remember that there is always the possibility of some external event beyond your control — say, a terrorist attack, an earthquake in California or some other “Black Swan” event — that can cause Lehman Brothers and the market to drop unexpectedly.

So you calculate your position size so that the WORST that could happen is that you lose 1% of your portfolio. You place your stop at the same time that you buy your stock.

So how would you feel that fateful Monday morning?

You may be a bit disappointed — but, frankly, given that you knew your worst-case scenario ahead of time, you had psychologically accepted that this could happen. You actually feel good about yourself for having stuck to your discipline.

In fact, I can tell you exactly how that Monday morning felt… Because I actually placed that bet on Lehman Brothers myself!

So what was my reaction to Lehman’s demise? “It’s not that big of a deal!”

The lesson: Be sure that you NEVER bet too big on any idea — no matter how great it seems…

And I’ll let you in on another secret: sophisticated hedge funds screw this up all the time!

In fact, the next time you hear about a hedge fund blowing up, you can be 100% sure that it was due to a hedge fund manager getting too cocky and taking too big of a position in his fund — or not sticking to his stops.

But the very best hedge fund managers think differently. George Soros lost hundreds of millions on this bet on Lehman Brothers. But his loss still was manageable — given the size of his portfolio. As Soros says:

“I’m very concerned about the need to survive, and not to take risks that could actually destroy me.”

Or as Larry Hite, top trader interviewed in Jack Schwager’s “Market Wizards” put it:

“Never risk more than 1% of your total equity in any one trade. By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.”

Here’s my personal rule of thumb: I never risked more than 0.5% (that’s ½ of 1%) on any one idea for any of the hedge funds that I traded. If the trade went in my direction, I’d just add to it… But those are details I can’t get into in this Special Report.

A Simple Four-Step Technique That Can SaveYou Millions over Your Investment Lifetime

So here it is: A simple four-step technique to manage your risk on any single Alpha Investor Letter (or ANY) investment idea.

STEP 1: Establish the size of your trading portfolio.

What’s the total amount of money you are willing to play with in your short-term trading portfolio?

For the purposes of this example, I will assume it is $100,000.

STEP 2: Decide how much you want to risk on an Alpha Investor Letter investment idea.

I will sometimes give you some guidance on this. I will often say whether the idea is “high risk” (say, a highly volatile Turkish ETF) or “low risk” (like a very steady currency ETF).

For whatever reason, you may be more comfortable with some ideas than others. Or maybe you have some special insight into that portfolio pick that gives you an “extra edge.” Or maybe the overall market has entered a bullish phase, and you are willing to risk more on your investments.

But ultimately, how much you are willing to risk on any idea is up to you.

For the purposes of illustration, let’s say you are willing to risk 1%, or $1,000 (out of your $100,000 portfolio), on the current investment idea.

STEP 3: Calculate your risk per share.

If you’re like most people, you think that if you buy a share for $100, you are risking the entire $100.

But from now on, I want you to think about “risk” in a very different way.

Let’s say you buy a stock at $100 and you place your “Good ‘til cancelled” or “GTC” stop price at $85. You do both of these at the same time that you buy the stock with your online broker.

So here is what you are REALLY risking:

$100 entry price – $85 stop price = $15 dollars risked per share

Here’s what is most important to understand:

Once you place your stop, you are only risking $15 per share. (That assumes you “don’t run the red light” and you stick to your stops.)

By the way, you will always find a stop price for every pick you get with Alpha Investor Letter.

You should know that I put a lot of thought into each stop price. Although I can’t go into details here, each stop price is tailored particularly to each pick’s “personality.”

That means I’ll give more volatile picks more room to move than relatively stable picks. Sometimes, a stop will be as far away as 30% from the entry price. Others will be as near as 7% or 8%.

STEP 4: Calculate how many shares you should buy.

This is a crucial step.

Say you’ve decided to risk 1% of your investment capital on this month’s Alpha Investor Letter idea.

Based on the difference between the stock price and the exit price, you are risking $15 per share.

Here’s the important part: Take the 1% of your portfolio (or $1,000) that you are risking on this week’s Alpha Investor Letter idea, and divide it by the $15 per share you are risking on each share.

This will give you the number of shares you should buy.

Here’s the formula:

Number of shares = $1000/$15 per share = 66.66, or 67 shares (rounded up).

That means that you can buy 67 shares of this pick, for a total of $6,700.

Note that this many shares amounts to a 6.7% position in your portfolio… which is probably a lot bigger than you expected…

BUT… because you have placed a stop of $85 on each share, you are limiting your TOTAL RISK on this one idea to $1,000, or 1% of your portfolio.

Let Me Land the Plane Here…

I strongly recommend that you use this approach to calculate your risk and position size for each and every one of your Alpha Investor Letter picks. (And if I were you, I’d use it for every single one of your other investments as well.)

So every time you get your issue of Alpha Investor Letter:

Decide how much you are willing to risk on that investment idea. (I recommend you start small!)

Subtract the recommended stop price from the share price to calculate how much you are risking per share.

Divide the total amount you are risking by the amount you are risking per share.

And voila! You have the number of shares that you should buy, based on the amount you are willing to risk.

I like to tell my seminar audiences to view this technique like a set of training wheels on a bicycle. Use the formula a few times until you get the hang of it. Once you really get it, you’ll realize that you’ll be able to “ride the bike” as “fast” or as “slowly” as you want.

If you are feeling skittish about the market, you can “dial back” the risk you are taking to, say, $500 per trade, or even $100. Or, if you feel particularly bullish about the market or a certain investment idea, you can decide to risk $2,000.

The point is to focus on the “risk” that you are taking on each position. But within that, you can vary your position size to suit your own risk appetite.

The point is: It’s all up to you…

You… and not the market… are in control…

And by adding up the total number of dollars you are risking on any set of trades in your portfolio, you always know your “worst-case scenario” — that is, how much your entire portfolio is always at risk.

So try this technique and see how it works for you. Once you do it three or four times, it’ll become second nature.

Here’s to investing like a hedge fund!

Nicholas Vardy

Nicholas A. Vardy
Editor, Alpha Investor Letter

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