Jayesh Patel

Long Short Strategy

I recently came across an interesting investing strategy known as Long-Short Strategy (LSS). Being mostly a Long Only (LO) investor, Long Short strategy made an interesting reading for me and expanded investment alternatives that I can practice in stock market. I guess many of you also might like to know about this relatively unpopular investing approach. So here is the LSS as I know and perceive it.

How Long-Short Strategy (LSS) differs from conventional Long Only Strategy (LOS)?
LSS is mostly applicable to equity/stock markets. Here you attempt to eliminate or minimize market risk in contrast to the non-market (aka company specific) risk that a diversification strategy typically attempts to minimize.

Most of the investors in the market are Long Only investors. In Long Only, you try to select best stocks and buy them. If the stock goes up after you purchase it, it is your gain and if it goes down, it is a potential loss to you. This is what most of us do all the times in the stock market. Long Short goes one step further. In a typical LSS, besides buying stocks, you would simultaneously short sell some weak stocks (of course of a different company). Here the goal is to match long positions with short positions in such a way that it eliminates some risk. One would ask what is the benefit of going long as well short in the market at the same time? Isn't short selling too risky?

Investment risks
For an investor with surplus money, buying stocks and holding them over some period makes sense as stock prices tend to go up over longer time horizons. However if making money is the primary objective by exploiting security mis-pricing as many traders and market professionals do, one has to look at investment risks more closely.

Equity investment risk can be divided into two components:
A. Market risk: The movement in the overall market that influences stock prices.
B. Security Selection risk: Company specific factors that affect a stock's price.

Market Risk: Everybody knows about market risk. Let us say I buy BRCM because I think it is a great company. However a fluctuation in BRCM on a given day is caused by either the tone of the general market or some developments specific to BRCM. I tend to believe that on most, maybe as many as 80% of the days, the fluctuations in BRCM stock would follow the market. If the market does well, so does BRCM. If the market is down, chances are BRCM would be down too. However good BRCM maybe as a company, it is subject to overall market movements and investor sentiments. This is the market risk. It is not a bad risk. If you are a long-term investor, this is the risk that rewards you. If you saw your portfolio value skyrocket in early 90s and also saw it get into gutters in 2000-2002, the main factor behind it was this risk- market risk.

Security Specific Risk: Once we eliminate market risk from a given stock's total risk (price fluctuations), what we are left with is security specific risk. It is not easy but not impossible too, to segregate total risk into market risk and security specific risks. (Read the Modern Portfolio Theory and Performance Attribution methods if you are interested.) Luckily we don't need to know exact proportion of these two risks for various stocks to practice LSS. Just understanding them and acknowledging their existence and impact on our investments is enough.

During an investment decision process, we spend time figuring out what we should buy (security selection based on security specific reasons). However unless we are a very long-term investor, we are also taking a position on the direction of the overall market for our time horizon. Over a long term, markets tend to go up; but in between we may have years like 2000 and 2001 that are hard to live by. When we are long only for some specific time period, knowingly or unknowingly, we assume, or at least hope, that the market will go up. We may buy a great stock, but if the market keeps sinking, we would have hard time realizing our goal of making money on it. So security specific research/risk is of limited use when it gets mixed with market risk.

How to minimize risk?

Most of the investors know how to minimize investment risks: diversification. We are told that the more we diversify, the more we are able to eliminate the risk. This is only half –truth. As we know, investment risk has two components. With diversification, we reduce security specific risks. If BRCM has bad news, MO may have good news. If CSCO is going down, TYC may be going up. So when we look at everything in aggregate fashion, the company specific risks are somewhat eliminated in our portfolio. However, the benefit of diversification ends there. Diversification does not remove market risk from your portfolio nor does it help you exploit company specific research. If the Dow were down by 200 points, sure your diversified portfolio would have a bad day too. If the S&P 500 return were negative 20% last year, your diversified portfolio would also be in more or less loss. If you have CSCO in your portfolio and say it goes up by 10%, it does little good when we look at the portfolio level. A 5% CSCO position would influence a portfolio's return by 0.5% assuming all other things equal.

So in Long Only strategy, we are rewarded for market risk we take.

Investment strategies based on the risk we want to take:

Any investment decision-making process should ask this question first. What risk we want to take?

• If you want to take market risk but eliminate company specific risk, you should keep doing what we, most investors, have been doing for all these years. Buy stocks and build a diversified investment portfolio. This is nothing but Long Only strategy.
• If you want to take market risk as well as company specific risk, you should do a thorough research and buy/sell stocks based on their prospects as well as your expectations about the overall market return. You should maintain a portfolio with concentrated positions in few stocks. Diversification should be avoided here.
• If you want to take no risk- neither market risk nor company specific risk, come on. Don't spend time reading this article or looking around on Internet. You would be better off giving your money to banks, US Government  or by keeping surplus in insured money market accounts, CDs or Bonds.
• If you want to take company specific risks only but no market risk, enter to the wonderful world of Long Short investing.

Long Short Investing:

LSS (Long Short Strategy) is often referred to as market neutral investing as it attempts to eliminate market risk from the portfolio. LSS is not suitable for all investors though. It maybe suitable for those investors

• who think they have superior security selection skills
• who think their market timing skills are poor or they want to eliminate market risks.
• who want to benefit from upside potential of promising stocks as well as benefit from downside risk of weak stocks.
• who have more risk appetite than most investors. (This is disputable. A Long Short may not be riskier than Long Only!)

How to implement LSS?

In loose sense, you may want to find one bad stock for every good stock you want to buy. If I want to buy BRCM, I would also need to find a stock, let us call it X, to short which is expected to do bad. Holding both stocks together, one long and one short, would help remove most of the market risk from the combined position. If market goes down, BRCM would go down so you would lose on your long position. However stock X is also likely to go down with market. As you are short on X, you have a profit there! Thus market impact is minimized. If our security selection skills are superior, BRCM would do better in comparison with overall market and X would do worse. Let us assume that the markets are down by 20% during our investment horizon. As BRCM did better than market, it maybe down by 10%. As stock X did worse with respect to the market, it may be down by 30%.

So our profit= Return on long position - return on short position.

Profit = (-10%) - (-30%) = 20%

Another scenario. If markets did well with S&P 500 return of +15% with return on BRCM of 30% and return on X of 10%.
Profit in this situation is again = 30% - (10%)= 20%.

There is one more advantage. In Long Short, you pay for the long positions but your account gets credited with short sell proceeds (depending on margin laws). This results in excess portfolio liquidity in comparison with a Long Only portfolio. So proper cash management can add some extra return to a Long Short portfolio.

This is how a typical Long Short Strategy works. It eliminates market risk and rewards you based on your security selection risk. However if our security selection turns out to be bad, Long Short becomes a double-edged sword and we may end up losing more in this strategy. The stock we are long may do worse than the stock we are short and we may get hurt on both positions.  

So a key element for a success in Long Short strategy is our security selection skills.

Risk Control in Long Short Strategy:

1. Pair diversification: You make a pair of trades (long and short positions) instead of looking at aggregate long and short positions at the portfolio level. (This is somewhat contrary to Long Only. In Long Only you look at risk at the portfolio level and not at an individual stock level. However in LSS, you look at risk of a pair of trades). Say you like Pfizer in Drugs sector but you don't like Merck due to their prospects over next two years. Both being in same industry/sector, they both are likely to be equally affected by market as well as industry specific reasons. So they make a perfect long-short pair.

2. Beta: Beta is a measure of a stock's volatility with respect to market. So we may want to make a pair of long and short stocks that have equal beta. Equal beta shows identical sensitivity to market risk.

3. Sector positions: Let us say at a particular point in economical cycle, you like retail stocks but don't like housing stocks. So you may want to take long position in a retail stock(s) but short position in a housing stock(s). Here we are trying to avoid market risk and focus on industry specific reasons (along with security specific factors).

4. Equitizing a Long Short Strategy: Sometimes it pays to take market risk if our view is bullish or a bearish on the market. With Long Short, we can buy/sell index Futures to take a position on the market or we can have a  long short ratio that is less or greater than 100%. For say 1 million dollars in long positions, we may have 500,000 (if we are bullish) in shorts or 1.5 m (if we are bearish) worth of short positions.

5. Diversification:  It helps to have more long-short pairs in the portfolio than only a few pairs. This is the same old diversification argument. When you have more pairs, your portfolio return becomes more stable.

Caution:

§         Long Short attempts to eliminate market risk but magnifies security specific risks. Hence it is more suitable for investors who have superior security selection skills.

§         Short-term fluctuations in stock prices are less predictable than long term ones. So you need to give this strategy a reasonable time instead of cutting it short due to unfavorable short-term developments.

§         It is beneficial to practice diversification and have more long-short pairs in the portfolio. This tends to eliminate overall risk of the portfolio.

§         When practicing Long Short, you have to keep some short selling limitations in mind. You can’t sell short on a down tick. For a short sell, you or your broker has to borrow shares for you and there is a risk that you may have to cover your short prematurely if the shares are recalled. Though it rarely happens, a bear trap in a stock you are short may cause the stock price to go up much quickly than would be normally justified.

§         You need to have a well thought exit strategy. Would you close both positions simultaneously? What if one of the stocks in your pair has some unexpected developments? What if one of the stocks in the pair has reached its target but not the other?