What Is Long Short Equity in Stock Trading? A Beginner’s Guide to The Long Short Equity Strategy. • Benzinga

One way that big investors try to mitigate risk and maximize returns is to play both the ups and downs of the market through a strategy known as long-short equity. 

The formula is simple, but making it pay off may require the kind of resources available to hedge funds and other more sophisticated investors.

Here’s how long-short equity works. 

Understanding Long-Short Equity

Simply put, a long-short equity strategy involves taking a long position in undervalued stocks that are expected to rise and a short position in overvalued stocks that are expected to drop. 

The strategy aims to mitigate risk through diversification, since investors are dividing their long and short holdings, such as 80% long and 20% short. But it’s still not risk-free. A long-term investment could unexpectedly drop and wipe out gains from short positions while a stock bought on margin could rise, resulting in a loss to an investor who bet on a decline. 

Properly implemented, however, a long-short equity strategy profits on both gains and losses, achieving greater earnings than if an investor had focused on one direction.

How Long-Short Equity Works

A successful long-short equity strategy requires deep technical knowledge and research, like the kind available to hedge funds. An investor should be able to identify undervalued stocks that are ripe for a long position and overpriced stocks that are ideal for shorts.

As a starting point, fundamental analysis can help uncover mispriced securities. Once it’s complete, the investor should have a list of stocks to allocate holdings among portfolio weights. For instance, they might invest 25% of their available money in shorts and 75% in longs. 

After an investor makes the appropriate trades, diligent portfolio monitoring is necessary. Most investors set a certain percentage of losses they’re willing to accept before they give up their holdings. That way, they prevent unexpected losses that could be severely detrimental to their investment strategy.

For example, an investor performing fundamental analysis to identify mispriced stocks determines that Alphabet’s current price of $180 is undervalued, while Eli Lilly’s price of $780 is overvalued. They take a 70/30 long-short allocation, buying seven shares in Alphabet and borrowing six in Eli Lilly on margin. 

Over the next month, Alphabet’s share price rises to $200, and Eli Lilly’s falls to $750. Alphabet’s gain results in $140 in profits (7 shares x $20 share increase), while Eli Lilly’s yields a $180 profit (6 shares x $30 loss). In total, the long-short equity strategy yields $320 in profits.

Stocks within the same sector often move up or down in unison, which means choosing stocks from different areas of the market is generally favored for long-short strategies.

Equity Market-Neutral Strategies vs. Long-Short

A market-neutral equity strategy involves holding equal positions in both long and short holdings, say in a 50/50 split. Unlike long-short strategies that divide their long and short positions between different sectors, a market-neutral strategy looks for similar investments on both sides of the trade. It’s more of a bet on particular stocks than a focus on sectors, and it also requires constant monitoring to ensure the portfolio remains balanced.

Who are Long-Short Equity Strategies Best For?

While individual investors can attempt a long-short equity strategy, they probably won’t have access to the resources available to a hedge fund or other more sophisticated money manager. If you think it’s a viable option, you should seek the help of a financial advisor with proven experience handling long-short portfolios.

As with any other investment strategy, long-short equity involves risks. Successful implementation can help protect against unexpected changes in the market, but make sure you’re comfortable with the potential downsides, and do your best to mitigate them before going forward.

Frequently Asked Questions