Long/Short Basics

There are three kinds of risk in the market. There is Market Risk incurred by all instruments in a market, Sector Risk incurred by all instruments in a sector, and Asset risk specific to the asset. Asset risk is especially derived from the way the underlying company is managed. The goal of a successful long/short equity portfolio is reducing all three to some or a major degree while simultaneously beating the market. If you can repeatedly do this, you will be a successful investor.

To reduce market risk, you must reduce the standard deviation of a portfolio. The volatility of the swings within the portfolio are a measure of risk, with higher violent swings in portfolio value being riskier, especially if you’re taking losses on those swings. If you are making gains those swings are still risky since they could easily have occurred against you in the reverse position. Under some methods of measurement, like Sortino, asset return deviations in your favor are not included as risk.

The goal of diversification is reducing the standard deviation of a portfolio. If you utilize 1 equity position your standard deviation should be 50%. As you add more positions that have low or no correlation, your standard deviation declines since they don’t all move up or down together. Note that diversification also diversifies returns. If you had 1 equity investment and that investment beat the market by 10%, your portfolio would beat the market by 10%. But if your single investment tanked, so would your portfolio. After diversification, your portfolio is less individual asset driven.

At 50 equity positions you will have roughly 20.2% standard deviation. Around 20% you will find it extremely hard to diversify market risk. If you build a long only portfolio of 1,000 equities (essentially a very large mutual fund) you will still have a standard deviation in the upper teens. Most of this is due to all positions being long market positions. When the market crashes, people pulling their money out of the market, especially funds that own large amounts of shares, sell shares and force funds to sell off. This selloff drags down the value of almost all equity shares in that marketplace.

Long/Short Equity & Risk Mitigation

By utilizing diversification with long/short equity positions you can minimize almost all market risk. If the market moves down your long positions suffer losses that are reduced or canceled out by your short positions’ gains. If the market moves up your short positions suffer losses that are reduced or exceeded by your long positions’ gains. This reduces the effect of market risk. After this point, your only concern is being absolutely certain the probability of long positions increasing in price and short positions decreasing in price are maximized. This reduces the chance of long and short trades “surprising” you. When they do diversification kicks in and reduces the effect on your portfolio.

Success is merely an issue of stacking probabilities, eliminating losses quickly, adding more winning trades, and adding capital to winning trades. Your goal is to eliminate nearly all market risk by any measurement, ensure that sector risk is either eliminated or in your favor, and then ensure you are on the correct side of asset risk. If retaining sector risk, you want your long investment sectors to be trending up for economic reasons, and your short sectors to be trending down for economic reasons. Afterwards, you want the assets held long to be economically, fundamentally, and technically trending up. Assets held short are economically, fundamentally, and technically trending down.

The Long/Short Equity Process

To pick successful long and short equity positions, start with the macroeconomic, market sentiment, and sector levels. This lets you identify profitable investment themes. You filter out bad potential equity positions by utilizing fundamental and technical screens, leaving only highly likely ideas for long and short positions. Finally, you measure risk by calculating several quantitative measurements to ensure that your portfolio won’t be melted by a breakdown in one asset or industry. Your goal is to screen companies by their appropriateness for your system driven positions. Longs take advantage of positive trends while shorts take advantage of negative trends.