How Do Hedge Funds Work?

BY busadmin  May 21, 2010 at 2:19 PM EST

Question: How do hedge funds work? How do investors gain money from betting on losses?

Paul Solman: One way is to borrow an asset like a stock from a broker and promptly sell it, betting it will go down in price before having to buy it back to return to the lender. This is called selling “short” or “shorting.”

Another way is to buy an “option” that gives you the right to sell an asset to someone at today’s price on some specified date in the future. You get the difference between the price today and the price on the day the option expires. So I can buy an option to sell 1000 barrels of oil at today’s price of $70 by next December for a few dollars a barrel. If oil drops by more than the price of the option, I’ll make money.

There are fancier methods as well, but these are perhaps the most common.