What does it mean to go long or short in trading stocks?
Going long and short at the same time may help reduce market risk
Long/short equity investing involves going 'long' equities, you are buying on the expectation of an increase in value and by going 'short' equities, you are selling on the expectation of a decrease in value.
long position is holding a stock that you expect to appreciate.
short position is holding a stock that you expect to depreciate.
Since its inception in 1949 by hedge fund manager, Alfred Winslow Jones, the long/short equity strategy is now, by far, the most popular of all strategies amongst the global investment industry.
Combine the two actions by using investment research to uncover expected winners and losers and you can effectively record a profit while better managing your investment risk. Put simply, by employing this approach, you are pledging long positions in expected outperformers to use as collateral to finance short positions in expected under-performing stocks.
Long/short equity investing therefore presents many benefits and opportunities not available through traditional means of stock trading. Long/short trading style is also popular because they can be employed across a range of different geographic regions, sectors and industries or can be applied to market-cap-specific stocks.
Employing this technique means you must identify what you consider to be an undervalued stock (to buy, take a long position in) and an overvalued stock (to sell, take a short position in).
Ideally, you want your long position to increase in value and the short position to decline in value. If your long position outperforms your short position and both positions are of equal size, you stand to make a profit.
For example: If you go long with an Apple stock for £1million while going short a Google stock for the same amount and the U.S. technology sector declines unexpectedly based on an event, you will stand to make a profit on Google while registering a matching loss on Apple.
Equally, in an event that causes both your long and short positions (Apple and Google) to rise, such as a rise in the market as a whole, it will have little or no effect on your long/short position.
This means that your long/short position should make a profit irrespective of market and sector moves if you've successfully predicted that Apple outperforms Google while also reducing your overall investment risk. Much of your success relies on your ability to predict 'winners' and 'losers'.
There are four key steps in long/short equity technique:
- Identify undervalued/overvalued stocks; use investment research to find undervalued and overvalued stocks on a fundamental and technical basis.
- Select appropriate stocks to go long/short: conduct a quantitative approach by researching the company and sector, analysing the valuation and historical price performance as well as forecasting future earnings potential.
- Execute a long/short trade: size a long/short position by how much you are will to invest and execute the trade in order to take advantage of short-term opportunities while managing risk with tools such as stop loss limits and orders.
- Manage your portfolio: build up your portfolio with a number of long/short positions across a range of geographies, sectors and market-caps and manage it by measuring performance over a period of time.
- Flexibility to trade a variety of stocks, sectors and geographies.
- Successful prediction ensure returns even in difficult market conditions.
- Reduction in market risk helps to minimise portfolio losses.
- To turn a profit, you must be able to predict which stocks will perform better.
- Buying and selling in multiple countries can create unwanted currency risk.
- Macro and geopolitical risk means that that if the market declines sharply, long positions can lose more than short positions.
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