A Simple, Powerful Strategy to Beat the Hedge Funds at Their Own Game

I've been telling you for weeks that hedge funds have been bleeding cash - not just during 2016, but for the past 10 years or more.

And in our in-depth analysis of hedge fund performance - what historically made them extraordinary, and moreover, what they're doing lately that's undermining performance - yields an easy-to-follow roadmap leading to both investing and trading success.

That's because these days, with markets being manipulated, being gamed, and being chased by too many hedge funds (and too many mutual funds), employing too many of the same strategies, getting into too many of the same stocks, and getting out too late means generating big returns requires a hybrid investing and trading strategy.

Employing both short-term trading and long-term investing strategies that incorporate what's worked and what hasn't worked is the best way to make tons of money today.

But the news is better for some investors than others.

Dow Jones Industrial AverageThe truth is, today it's easier for individual investors to make money running their own personal hedge funds than it is for the big boys to swing for the fences.

That's because nimble investors who know what big hedge funds and sloth-like mutual funds are doing right (and wrong) can actually mimic, "fade," and front-run funds into and out of positions.

It's not hard, it just takes a little work.

Here's why and how you should sometimes mimic, sometimes fade, which is a Wall Street insider term for "do the opposite" and always front run funds in and out of trades.

It's entertaining and enlightening work.

Making money has always been a passion of mine. Even though I retired from the hedge fund business (frankly, because it's a 24/7 job and because I don't have to work anymore and like sharing my days with family and friends), I still exercise my passion every day for the business.

I read a lot. I follow what my hedge fund friends are doing. I talk to a lot of big investors.

That's the kind of work I'm talking about. That's how you research the trades you're going to make in your own personal hedge fund.

Here's how you exercise your own passion to make money.

Do Your Homework

The analysis I laid out here over the past couple of weeks shows that hedge funds are crowding into too many of the same positions. So knowing who's in what and how big their holdings are is a big part of your basic research.

Big institutional investors who oversee pools of $100 million or more in assets are required to file quarterly 13F forms with the SEC. All of those 13Fs are available for free on EDGAR, the SEC's web search portal. Available in both HTML and XML form, the filings list all of the fund's long equity and option positions.

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While you can get all that information for free, it's a slog to get through unless you set up your own spreadsheets with sifting mechanisms, which isn't exactly easy. Luckily, there are web accessed "products" that distill the kind of data you'll need. For instance, Whale Wisdom tracks hundreds of hedge funds and provides analysis on several years of 13Fs. It also provides 13F backtesting and even scores funds based on performance. Either way, 13F information is required research.

While it's true that 13Fs are filled out at the end of a quarter and managers could have already moved out of those positions, you can look back at trading volume and price action over the preceding quarter and make some assumptions about money flows in or out of stocks.

But that's more granular. I do that, but you may not have time or the tools to calculate what could be net changes in hedge funds' positions. Generally, what you don't know doesn't hurt you because you'll be looking at positions held by a lot of funds, and it's not likely they've all already moved on.

Also, 13F filers don't list their "short" positions. So it's hard to tell if they are short as a hedge against the long positions you can see. While it would be great to see their short positions, there are other ways to zero in on shorting opportunities, not by the way to short them, but to actually fade the shorts and buy them (I'll tell you more about that soon).

Make Overcrowding Work for You

Basically, the overcrowding negative effect concentrated positions have on hedge funds is triggered when positions are exited.

It sounds simple, but it's working beautifully these days. If you know hedge funds have big positions in the same securities, on the same side of a bet, all you have to do is check out the technicals and look for support and resistance levels.

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Depending on how long funds have been holding those positions, and very often depending on which funds own what, both of which you can glean from 13Fs, you can front run their exiting by placing orders to sell your own position, which you may have gotten into by mimicking the funds, or short the stock when it breaks support levels.

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For me, if a lot of funds are in the same position and I've got a good handle on who the players are, their trading and investing styles, risk tolerance, etc., all of which I learned because of my passion, and you can learn too by just reading a lot of articles about fund managers, their travails and successes, the markets and reading those 13Fs. That's how I stage my trades.

I'll watch the various support levels and see what happens volume-wise when they get broken. You can tell by watching block trades and volume metrics, if the selling is institutional or retail. Depending on the number and size of blocks and volume, I can tell if funds are dumping.

Then, if I'm not convinced they're done, or if the stock is under more pressure, either from what's bearing down on it or because of systemic market pressure, I'll short more at lower levels if next levels of support get broken on bigger volume. That's funds selling.

Of course, if you have a good handle on the players and their portfolio management styles, and how many are in the same positions, it's not hard to figure there may be more heavy selling if another support level is broken.

The biggest problem hedge funds are facing when they are bunched together in the same long positions is getting out with profits, or at breakeven, ahead of the rest of the sellers.

That's why this simple strategy is so powerful. It's easy for small investors to do because they can be more nimble. Yes, big funds are aware of that, but they're not worried about small investors front running their selling. They worry about other big investors heading for the exits before they get out of harm's way.

How to Play the Short Side

Playing the short side of hedge fund positions is pretty much the exact opposite.

When funds are short, they're either long-term short position holders, or (far more often) very short-term short position holders.

It's not that important to watch long-term short position holders (funds like Jim Chanos' Kynikos Associates) because they aren't generally who small investors should follow. However, they make waves when they call out a stock as a good short prospect. Pay attention to that.

The short-term short position holders are usually a nervous bunch who don't like that they're facing a long bull market and the prospect of unlimited losses, since stocks can technically go up forever - they're the ones I watch.

Again, reading and keeping up on what the financial press is saying about funds' positions is important. I also look at the number of shares shorted and the percentage of a stock's float that's been shorted. Both of those stats can easily be found on Yahoo Finance under "statistics."

Especially if the market starts moving higher, quickly, those shorts are going to panic.

I love buying those stocks, especially if I want to own them anyway, if there are large short positions on them. Up-moves will cause shorts to cover. The bigger the short position on a stock, the more of it I buy looking to front run short-covering funds.

It's really that simple.

Both playing from the long side and the short side, by nimbly front running hedge funds, sometimes mimicking their going-in plays, but far more often front running their exiting moves, can be extraordinarily profitable.

I'll give you hedge fund positions in the future and tell you how to play them, that way you'll see how easy it can be if you do your research and make sensible, nimble moves.

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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