For both retail and professional investors alike, most portfolios should strike a balance between risk mitigation and profit seeking.
Long-short equity investing is one strategy that many large-scale investors use to pursue that. In a long-short equity approach, the investor takes a mix of long and short positions, hoping to create a portfolio that is balanced to take advantage of both growth and depreciation in the market.
What is a Long Short Equity strategy?
Long short equity strategy is a popular strategy used by many hedge funds where long positions are taken in stocks that have superior return characteristics and short positions are taken in stocks that have relatively weaker characteristics (the rationale is that the long positions are expected to increase in value whereas short positions are expected to decrease in value).
(Check out our previous post to know more about trading strategies)
A portfolio constructed in this fashion helps to protect from losses during the market crash. Therefore, this strategy is sometimes also known as a market-neutral strategy.
It is a mixed portfolio. Most long-short strategies emphasize the long position, often taking a 70/30 mixture of long vs. short positions. This is not necessary, however, and a particularly pessimistic investor could even emphasize short positions if they felt that was wise.
Due to the market’s general upward trend in recent years, long-short portfolios that strongly emphasize short positions have been less popular.
Many long-short portfolios will emphasize particular markets or geographic areas.
For example, an investor could build their portfolio around a specific sector, like technology or automobile firms. This approach will help protect the performance of the portfolio from price fall in any of the sectors and makes the portfolio less volatile.
Why Take A Long-Short Equity Position?
There are three main reasons to use this strategy.
- Mitigate Systemic Risk
The main reason why large funds take a long-short equity position is to insulate themselves against marketwide exposure. If the market as a whole gains value, as it typically does, a portfolio that emphasizes long positions will profit. (Although the investor hopes to have nevertheless correctly identified overvalued stocks.) However, if the stock market declines overall, the portfolio’s short positions will partially insulate it from losses.
- Maximize the Spread
The other major goal of a long-short position is to maximize “the spread.” This is the difference between the long positions an investor has taken and their short positions. Ideally, investing this way allows an investor to gain on both growth and losses, creating more room for profit than by just investing for market growth alone.
- Market Neutral Positions
A less common goal for long-short equity is to build what is called a “market neutral position.” In this case, the investor will have invested the same amount of money in short positions as in long ones. The goal of this position is to insulate the portfolio from the market altogether, taking similar losses and gains from overall market trends up or down.
How to build the Long Short Equity strategy?
A long short equity strategy is built with the following steps:
Step 1 - Define the Universe
Step 2 - Stock Bucketing
Step 3 - Define parameter to long or short security
Step 4 - Capital allocation
Let's now learn about each step in more detail and create our own long short equity strategy.
Step 1 - Define the Universe
Identify a universe of stocks in which you can take positions. The universe can be defined based on trade-volume, market capitalization, price, and impact costs.
Step 2 - Stock Bucketing
From the universe of stocks, you can bucket stocks based on the sector such as technology, pharmaceuticals, automobiles, financial services, and FMCG.
Step 3 - Define parameter to long or short security
This is the key step in the workflow. You can rank stocks in the bucket based on their past returns performance. Stocks that have performed well will be ranked higher and stocks that performed poorly will be ranked lower. You can use a combination of parameters such as quarterly earnings growth, PE ratio, P/BV, moving averages, and RSI with different weights on each parameter to create a custom profitable strategy suited to your trading philosophy. You can go long on stocks with the lower rank and go short on the stocks with the higher rank.
Step 4 - Capital allocation
Allocating an equal amount of capital to each stock shortlisted from step 3 is a popular capital allocation strategy. An equal weight approach helps to avoid a concentration on a particular stock in the portfolio. Alternatively, you can distribute your capital based on weighted parameters derived from and suiting your trading style.
Choice of the ranking scheme for the Long Short Equity strategy:
- The choice of ranking scheme is the most critical component of this strategy.
- It is also a very important decision whether to use momentum or mean reversion when ranking the stocks as different stocks would have different behaviours. This decision is for you to make based on your preferences.
- Another popular strategy is to use fundamental factors like the value and performance of the firms using a combination of P/E ratio, P/B ratio, profit margins, earnings growth, and other fundamental factors to come up with a ranking scheme.
Long-Short Investing And You:
While long-short investing is typically employed by major funds, you can use it to diversify your own personal portfolio as well. But first, a warning: Short positions are extremely risky for the average investor. While a stock can go no lower than zero, there’s theoretically no upper boundary for how high its price can climb. This means that unlike a long position, a short position has potentially unlimited losses.
With that caution in mind and relevant stop-losses in place, as an individual investor you could also use a short position hedge against market-wide risk.
Long-short investing is a diversification strategy that involves taking both long and short positions in the same portfolio. It allows you to hedge against systematic risk by investing in stocks that will profit even during a market-wide decline. To start building your stocks bucket, create a dedicated market watch on your ShareIndia web app or mobile app. To open a new trading and DEMAT account online with ShareIndia in a few clicks, start here.
Disclaimer: Any Advice or information in the post is general advice for education purpose only and is not responsible for generating any trading profits for anyone, please do not trade or invest based solely on this information.
