Taking a look at the long-short hedge fund strategy,

A common strategy to help stock pickers gain from investing in companies, whilst reducing market risk, is via a long-short strategy.

In its simplest form an investor takes a long position in a company they feel is strong, and a short position in a company they feel is week. The difference in performance between the two share investments is where the profit lies, not in the overall performance of the stock-market.

The expectation is that in a rising stock-market the strong company should create enough profit to outweigh any losses form the weak company. Vice versa, in a falling stock-market the gains on the short position should outweigh any losses from the investment on the long position. Creating profit opportunities in both a rising and falling stock-market, hence the market risk is reduced.

The Khan Academy provide an excellent introductory video:

So for example, if you believe that Microsoft is performing well, and Coca-cola is not, then you could buy a long position in Mircosoft and take a short position in Coca-Cola. In this example regardless of how the S&P500 performs (the stock Index for the US Large cap companies), there is a potential for profit.

The key to this strategy is still in the stock (company) selection, however it removes some of the need for good market timing. It is no longer necessary to catch the market at the wrong time, as long as the company you buy does well, and the company you short does poorly, over the term of the investment.

One important factor in this strategy is volatility of the asset. Not all company shares move up and down at the same pace. For example small-cap shares will move at a different pace to large-cap shares. If one moves faster than the other, it will effect the profitability of the hedge. The strategy relies on the two investments having a relatively similar volatility level. If it is not possible to find similar Beta, then it can be compensated for by buying/shorting the two stocks in differing quantities.

One way to measure volatility of a stock investment in relation to the overall market, is via it’s Beta coefficient. If a stock has a Beta coefficient of 1.2, it moves 20% more than the stock index itself. For example if Microsoft had a Beat 0f 1.2, it moves up and down 20% faster than the S&P500. As the Beta is calcualted on historical data it is not a guarantee of future volatility, however it is a good guide for comparison.

There are a number of websites that publish Beta values, for example ABG Analytics

About the author

Trading and Investment

Traded the markets for over 15 years, including Commodities, Bonds, Currencies, Equities, and Indices. I have also worked as a Chartered Financial Planner.
CeMAP, CeFA, DipFA, AdvDipFA, Ba(Hons) Economics, Chartered ALIBF

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