Home » Long/Short Equity | Definition, Risks and Investment Strategy

Long/Short Equity | Definition, Risks and Investment Strategy

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Long-short equity

Long-short equity is a popular investing strategy where the long and short positions are taken on different stocks which are expected to incline or decline respectively. This strategy is used by many private firms, hedge funds, or individuals to get quick and high returns. The fund manager will utilize their clients money by investing in such a fashion that the overall invested capital is divided into long and short positions.

Understanding Long-Short Equity

Long short equity investment strategy gives the investor the opportunity to invest in an inclining market as well as a declining market. This increases the market coverage and also the higher profit at the same time. In long-short equity, two things are happening simultaneously. That is, buying the stocks that are expected to increase in value and selling short positions that are expected to decrease in value. 

The long positions are pretty straightforward and can be understood as buying the stocks of the company to hold it for the long term. In the long term, the companies which are undervalued will generally incline and profit is also predictable. The risk factor is also less as compared to short selling. 

The short positions are the ones in which the investment firms like hedge funds or mutual funds will borrow the stocks of a company that are expected to decline. Now, they will sell these stocks at a market price and once the value of the stock is decreased, they will again purchase the same amount of stocks making themselves a marginal profit. With short selling, there might occur unexpected risks like a short squeeze. 

Final Outcome of Long-Short Equity

There are three possible outcomes while implementing a long/short equity strategy: 

  • Double Alpha: This is the scenario in which both the short position value declines and the long position value inclines and gives you the best possible result. 
  • Single Alpha: This is the scenario in which either the long position or the short position moves favorably as expected by the investment manager.
  • Double Splat: This is the scenario in which neither the long position nor the short position performs well. This is the worst-case scenario and the investor might lose hugely.

The fund manager obviously tries to get that double alpha but the single alpha is also good enough to have enough profit if invested properly. This does not mean that single alpha always returns the profit, there could be a losing scenario but the overall loss will be minimal. 

How Long-Short Equity differs from Equity Market Neutral?

The investing strategy of both of these funds is quite the same. The only main difference is that the Equity Market Neutral funds tend to invest in long and short that are closely related. That is if the price of one stock rises then the price of another stock will fall. In this scenario, if you purchased the long positions for the stock that is supposed to incline then you will sell the short positions for the other stock. Equity Market Neutral is supposed to be a safer option than long-short equity.

Why use a long-short equity strategy?

Most investment firms use a long-short equity strategy to minimize the market loss and simultaneously earn higher profits. This also helps to maintain a proper investment portfolio as the fall or rise of the market has less effect on the loss from the investment. Long short equity is designed in such a way that the rise of the market will cause maximum profit and the fall of the market will cause minimum loss.

What is a long-short equity 130/30 strategy?

This is the strategy in which the investment in long-short equity is based on a 130/30 ratio. That is 130% of your investment portfolio will be from long positions and 30% will be from short positions.

Suppose that you have $1000 to invest. Initially, you will purchase all long positions making 100% of long securities. Now, you will borrow $300 worth of securities i.e. 30% of $1000, and sell them to take short positions. After selling those short positions, you will have 30% extra capital that you will again invest in long positions, making a total of 130% long positions. As you have 30% of short positions also, now your portfolio will look like a 130/30 fund. 

Based on past history, the 130/30 strategy provides about 90% of the benefit of leverage and eliminates most of the risk of losing your investment.

Long-Short Equity Risks

There are certain types of risks that the long/short equity investors will always come through:

  • Market Movement Risk: The long-short equity strategy totally depends on the prediction that the stocks might rise or fall. Although these expectations are based on the rumors, supply and demand history, etc. you may never know what unknown factors move the market undesirably. 
  • Short Squeeze and Long Squeeze: To hedge the losses due to the increase in the price of stocks that are supposed to decline and the decrease in the price of stocks that are supposed to incline can result in a squeeze. This scenario makes the investor feel that they might get a huge loss and try to trade more often to recover from their losses and the final outcome might not be as expected.
  • Improper Ratio: Investing in long/short equity needs proper research. Due to an improper investment ratio between short equity and long equity, the risk of losing increases. 

Final Words

Investing in long/short equity gives a higher probability of maintaining the return on investment and the overall portfolio. The long-short equity manager must have proper knowledge of what he/she is doing with the fund. One must have an entity that leads to the success of long-short equity is timing. The entry and exit of positions need to be properly timed and the movement of the market needs to be properly identified to generate more capital. Proper tools like SPACrun might help to analyze the market performance of different SPAC stocks and it also provides real-time alerts if there is any merger or ticker news. Subscribe to SPACrun now to get a free trial.

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