The Ultimate Temptation For Long/Short Traders

By: ispeculatornew
Date posted: 10.31.2011 (5:00 am) | Write a Comment  (3 Comments)

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I am currently reading a book about the history of hedge funds, which I will discuss in greater detail in the near future. One of the very interesting things that I’ve read is how funds that initially start being neutral have temptations to change that over time. What do I mean by “neutral”? There are many different ways this is used but the most used interpretation is when a fund owns and shorts an equal amount of dollars.

When we do long and short trades, we do exactly that as in a trade such as our only live one, Long Google and Short eBay, we will be buying $2500 worth of Google (GOOG) stock and selling the same amount of value of eBay (EBAY) shares. The objective of course is for market movements to have no impact on the trade as a 2% gain on all stocks would result in no gain or loss.

One would certainly argue that from the moment the trades goes live, it is no longer “neutral”. Why? Because if the price of Google increases by 1% while eBay’s doesn’t, the $2500 would now be worth $2750 and the fund would be “net long” $250. That is one reason why funds are rarely “100% neutral”. As of writing this, that trade is slightly up giving me a small “positive exposure”.

Another interpretation of being neutral is looking at the beta which we took a in-depth look into earlier this. Why? Some stocks such as Baidu are much more volatile than others like Exxon so being long on one and short the other would not necessarily make a fund “immune” to big market movements.

The End Goal For Me Remains To Be Market Neutral

While I do not want to be constantly rebalancing my trades, I do start them all as neutral trades which gives me a very small exposure in terms of dollars and even from a beta perspective. The impact is that my returns should be judged on an “absolute basis” rather than compared to market returns. In many ways, it is good because it provides additional diversification from more standard portfolios or even from dividend investing. Absolute returns means that every year, my trading objective could be a 7-8% gain with the hopes of having some exceptional years (such as 2011, with a 90% return so far) and limit losing ones. That compares with “long only” funds that will try to do a bit better than the indexes every year. Even beating the market by 1% can often be seen as a success, no matter i the market returns 20% or -20%.

Temptation Arrives

In the past few years, markets have been very volatile but the overall result has been fairly steady which has been neutral from my perspective. However, think about a market where indexes rise 20% per year for 3 or 4 straight years? My 7% would still be good considering my fund but I would be underperfoming “long funds” severely and there would certainly be a temptation to shift my trading towards being “long”. How? For example by being long $2500 and short $2000 for example.

Once that is done, I would probably be tempted to increase that amount event more and in the end might not be doing as much of the “shorting” part. That is precisely what has happened to a number of large hedge funds over the decades as they changed their trading styles to better profit from trending profits but did not reverse in time to avoid the inevitable market correction. The opposite would also be possible as a fund that has great success in shorting stocks during a market crash could slowly “abandon” the long parts of the trades.

Please Call Me Out

If ever you see trades, commentary or anything else here or on our free newsletters that seems to indicate that my technology trading is shifting and that I’m falling to the “temptation”, please call me out, I would certainly appreciate it.

Please Tell Me

Have any of you suffered temptations to change your trading or investing “style”? What caused it? Market trends? Personal events? Anything else?

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  1. Comment by Andrew — October 31, 2011 @ 11:54 am

    I can understand why you would want to be perfectly hedged in such a volatile current market with the averages up and down 20% in a matter of days. However I don’t understand why it is incorrect to adapt to a situation such as a long term cyclical bull or bear market by re-weighting to the long or short side. The only caveat is that when valuations become excessively cheap or expensive, it would probably be time to return to long short pair trades…

  2. Comment by Doctor Stock — October 31, 2011 @ 4:18 pm

    Volatility has always been a challenge whether for the long term or short term investor. Recently, I dived into paper trading a daily strategy I call the Evening Investor Strategy. It works well to react more quickly to the market volatility and produces more predictable results in more volatile times.

    Playing two sides of a trade can be ok if it breaks out of a range… but within the range, people tend to lose on both trades when their emotions get in the way.

  3. Comment by Intelligent Speculator — October 31, 2011 @ 6:47 pm

    @Andrew – Not saying it’s not a good idea but I think that each strategy should be used with discipline, I personally have a longer term portfolio that is long only and might hold more cash in periods like this one but the long/short trades for me should be more about finding undervalued stocks rather than being on the right side of the market

    @Doctor Stock – How exactly does the Evening Investor Strategy work?

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