What you need to do long/short pair trades

By: ispeculatornew
Date posted: 12.13.2010 (5:00 am) | Write a Comment  (1 Comment)

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All of the trades that are done on IntelligentSpeculator and that you can review here are long & short pair trades. We often receive questions about these types of trades and while we have discussed some of these aspects in the past, others were not discussed as well and for that reason we decided to write a bit more.

Why do long & short trades instead of simply buying a stock?

There are many reasons to do so and each investor would come up with a different answer for here are my answers:

No view of the entire market required: I follow technology stocks more than other and those are the stocks that I feel the most comfortable trading at the moment. But buying many technology stocks certainly has some risks. Why? Because if the markets drop like they have a done a few times in the last decades, chances are that I would be a big loser. Since my focus is so specific, I prefer having a long and short position. That means that when I initiate the trade, I am not directly vulnerable to a market collapse. Why? Because even if the market dropped 20%, I would likely see both stocks drop by more or less that amount which would mean a big loss on the long position and a big gain on the short position. Of course, the opposite is also true and I would not profit from a big gain if the markets jumped by 20%. So trading long & short means I do not have to worry about the overall direction of the market

Single focus: When I do a trade on Google and Baidu for example, the factors that will affect my trade are much smaller. It’s not about finding the best investment in the entire stock market but simply finding the stock between the two that will perform the best. It becomes a much easier environment to analyze for that reason.

Open a Brokerage account

Like any other investment, you must start by opening an account with a broker. It takes time and patience and a small deposit (depending on each broker) but other than that it’s fairly simple.

You need a Margin account

By default, your account will have “cash accounts” where you can buy shares for cash. However, when you do long & short trades, you need the possibility to do short trades which requires having a margin account. What does that mean? It means that you will be required to post a “margin” for every “unpaid” position. You can still manage long positions the same way but it gives you more options when you want to buy stocks on margin (which will not be discussed here) or open short trades.

No cash, just margin

You have to visualize this part. If you buy for $10,000 or Google (GOOG) stocks and sell for $10,000 or Amazon (AMZN) stock, your end result will be:

Cash= 0$
Positions: +10$K of GOOG & -10$K of AMZN

Yes, you read that right. The trade requires 0$. Does that mean you could have traded $1 million? No, probably not. Since the broker always has the risk that you will be unable to close out your trade (since the short position could lose a lot more than $10K). Generally, the broker will require that you post a margin close to 70% or $7000 in this case. The margin will vary depending on many different factors such as the correlation between the two stocks and the risk involved from the broker’s perspective.

Safety blanket

What you want to involve in such positions is getting margin calls. What do I mean? If the long position loses 20%, you will suddenly have more exposure and might get a margin call from that broker. That is a call to add money to your account. If you do not send it in time, the broker will close out your positions for you. That is one of the worst case scenarios and one that you want to avoid as possible. How?

If you have a long only portfolio such as a passive income dividend portfolio, you would also want to have those positions in the same account which will help your margin position.

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1 Comment

  1. […] the subjects that I get the most questions about is the method I use for trading technology stocks; long and short. I have written about it in the past and certainly have been fairly broad when discussing it which […]

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