Q. We hear about “long-short” strategies a lot in the hedge fund world. What are they?
A. In a long-short strategy, a manager is picking two stocks in the same industry, and predicts that one will outperform the other regardless of the general direction of the market. When done right, the fund makes money whether the general market goes up or down.
Q. OK, sounds good, how does it work?
A. Let’s say I’m a tech fund manager using a long short strategy. I might conclude that, regardless of overall market movements, IBM will out-perform HP. To put the trade on, I might go long IBM and short HP. If the overall tech sector goes up, the long gains value, my short loses value. If the overall tech sector goes down, my long loses value and my short gain value. Therefore, I’ve hedged out the general market risk.
Q. Yes, but… where’s the profit come from?
A. Well, my big idea here is that IBM will increase its relative value to HP over time. So what I really think is:
- In an up market IBM will rise more than HP; my long will gain more value than I’ll lose in my short.
- In a falling market, IBM will decline less than HP; my short will increase in value more than my long will lose value.
And btw, the guys who really think they’re geniuses try to do even better. The hope they can pick longs that will actually make money in nearly any market, and that they can pick shorts that will lose money in nearly any market. That way, they profit on both sides of the trades… and get major bragging rights at the next hedge fund cocktail party.