What is Long / Short
A Long/Short equity strategy works by exploiting profit opportunities in both potential upside and downside expected price moves. This strategy identifies and takes long positions in stocks identified as being relatively underpriced while selling short stocks that are deemed to be overpriced.
A typical strategy would be to employ a Long bias such as 130/30, where long exposure is 130% and short exposure is 30%. Rarely would you employ a predominant short bias to the long/short strategy because historically it’s much more difficult to uncover profitable short ideas than long ideas.
These strategies can be differentiated from one another by market geography (advanced economies, emerging markets, Europe, etc.), by sector (energy, technology, etc.), by investment philosophy (value or growth), and so on.
An example would be a global equity growth fund, while an example of a relatively narrow mandate would be an emerging markets healthcare fund.
The Pair Trade
A popular variation of the long/short model is that of the “pair trade," which involves offsetting a long position on a stock with a short position on another stock in the same sector.
For example, an investor in the technology space may take a long position in Microsoft and offset that with a short position in Intel. If the investor buys 1,000 shares of Microsoft at $100 each, and Intel is trading at $50, the short leg of this paired trade would involve purchasing 2000 Intel shares so that the dollar amounts of the long and short positions are equal.
The ideal situation for this long/short strategy would be for Microsoft to appreciate and for Intel to decline. If Microsoft rises to $120 and Intel falls to $45, the overall profit on this strategy would be $30,000. Even if Intel advances to $55, since the same factors typically drive stocks up or down in a specific sector, the strategy would still be profitable at $10,000, although much less so.
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