Reader Question About Beta Considerations In Our Trading

By: ispeculatornew
Date posted: 06.29.2011 (5:00 am) | Write a Comment  (0 Comments)

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Today, we are answering a very good question that we received by email. As always, we are more than happy to get feedback and are more than happy to answer your questions.

Kenneth – “I had a question about your long/short portfolio. It seems to be that your long positions tend to have a higher beta than your short positions. This is just a cursory impression and I have no firm evidence of this. For example, your recent paring of BIDU and RST. This becomes a problem in a bear market, when BIDU drops faster than RST. Do you have an opinion about this?

First off, I would like to start by saying that this is a very interesting question and one that I’ve been thinking about but had not done appropriate search on the subject. Before getting started, I think it’s appropriate to explain what a “Beta” is in case some of you have not heard the term. A beta is the “correlation” of a stock with the overall market. A stock that acts exactly like the market (increases by 2% for a market increase of 2% and vice-versa) would have a beta of 1. A stock that reacts the complete opposite of the market would have a beta of -1.

I think it’s safe to say that the average technology stock has a beta over 1. These stocks outperform markets in good times and do much more poorly in bad times. The point that Kenneth makes is a very valid one and before looking at the data, I would tend to agree. Why? Because one of the more frequent ways that I use to select new trades is finding two stocks that trade at similar P/E ratios but have different growth outlooks. In such a case, I think it’s fair to assume that I would generally end up being long the higher beta and short the other one.

Why Being Long Beta Matters

In short, if I always own stocks that have a higher beta than the stocks that I short, it would mean that when the market rises, I would (all else being equal) gain and I would lose on market declines.

Difference Between Long/Short Trading And Market Neutral

I am well aware that my portfolio is not “neutral” and it is not intended to be. Generally, hedge funds separate these two categories. Long/Short funds will have the ability to buy and sell stocks but have a market exposure while “market neutral” funds should be dollar neutral (beta neutral would be even better but that is much more difficult to achieve).

How Big Has Been The Exposure?

I decided to take a look at all the picks made this year to get a better idea:

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Average Beta on Long Positions: 1.17
Average Beta on Short Position: 1.15

Surprising Result?

I’m very surprised to see that the beta is so close. I think what might have driven both Kenneth and my own impressions were trades like Long Baidu (BIDU) and Short Rosetta Stone (RST) which fit very well into that “beta exposure” example.

I’m not entirely certain but I will consider adding the beta to future trades as it will help me monitor residual market exposure to my positions.

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