Equity Hedging

When complete, you should have screened out poor candidates using economic, fundamental, and technical trends. Your remaining “candidates” are no longer candidates, but trade-able investment positions. The last things you need to do is match long/short equities into spreads and build your Long/Short equity portfolio. This requires creating Long/Short spreads, which involves equity hedging.

To create long short spreads in a portfolio you need to know how much capital you will be placing into each long/short spread. You shouldn’t invest all of your capital. If you have $200,000 of initial starting capital, placing all of it into a portfolio of spreads is risky for many reasons. You may invest before a black swan, or a major correction, or a market crash.

Handling Long/Short Portfolio Systems

In any case, things go wrong and bad things happen. You shouldn’t have all of your money initially in a system, at maximum 60%. The remaining 40% of your capital should only ever be added to winning positions, increasing the size of substantial winners by an additional 20% or 30% after the trade proves you are correct. If right, add money slowly to positions. If wrong, limit losses and hedge out risk.

Out of your initial $200,000 only invest $120,000. Out of that $120,000 you will create your initial set of spreads. Recall that we need roughly 50 positions to reduce standard deviation to 20.2%? Each position added moves you closer to only the market risk at 19% standard deviation. The long/short split reduces the market risk. Your gains from the short side cancel out your losses on the long side if the market moves down (incurs risk for the long-side), and your gains from the long side cancel out your losses on the short side if the market moves up (incurs risk for the short-side).

The result is simple: At 50 positions, 25 to the long side and 25 to the short side, we have effectively diversified our asset risk to the 20.2% market risk. Then by taking the long/short approach we eliminate out market risk. We merely have to be sure we aren’t weighted too highly to each sector and diversify sector risk. So we have 25 spreads of one long and one short position. We take $120,000 and divide it by 25 for a total of $4,800. Note that we are not dividing it by 50 positions. The reason for that is weighting.

Spread Development Requirements

Matching consists of four primary issues. You need (1) An Active Downtrend in the Short with an Active Uptrend in the Long Candidate, (2) Positive Net Dividend Inflow from the Spread, (3) The current share price of the long and short candidates, and (4) The Beta of the Long and Short Candidate.

The closest prices and closest betas should be tested first. Your goal is to have a near equal weighting for your long and short positions. This eliminates you being overexposed on either the long side or the short side. Test the closer beta matches first, then move progressively farther away.

Testing Beta

How do you test Beta? There’s a few formulas. First you need both the Long and the Short Beta. Divide the long beta by the short beta to get the beta ratio. The closer this is to one, the more even the split between your capital will be. It can (usually will) be slightly above or slightly below one. The next two formulas are for the percentage weights.

The capital for each spread will be multiplied by the percentage capital to the long and short side. If you’re using $4,800, this will split that money between the long side and the short side. This gives you the maximum amount of capital you can use on the long side and short side. If your betas were nearly the same, this occurs on almost a 1:1 ratio, which means you use almost exactly $2,400 for the long and short side. The further the imbalance in Betas, the greater the difference in capital allocations. Your equity hedging should still generally be accurate, since you’re weighting the distance each equity moves in relation to the market. It merely results in an imbalance in the amount of capital devoted to both sides of the spread.

Once you have the capital reserved, you need to get the amount of shares you can buy with that capital for both the long side and the short side. Divide that number by the current share price, and that is the maximum amount of shares you can take trade for each side of the spread.

Then you simply buy the long shares, and sell the short shares. This will give you a diversified long short portfolio after you have repeated the process for each one of your candidates. It is best if you put them into same-sector spreads to eliminate sector risk, and you can then easily replace one sector long/short spread with another one. There are roughly 11 sectors in the market: Consumer Discretionary, Consumer Staples, Energy, Financial Services, Financials, Health Care, Industrials, Materials, Real Estate, Technology, and Utilities. You should focus on 1 spread per sector until you have one in each, then 2 spreads per sector, with about 3 extra for either cross or inside sector spreads. This diversifies you throughout the market’s Sectors.