There is no question that a big majority of investors have a preference for taking the long view and therefore adjusting their holdings with a big bias on the long side.
On the other hand, there is a certain percentage of investors who take a contrarian view which translates to taking short positions in their portfolio.
The debate between long and short positions – or how much of a portfolio should be long or short, has been an ongoing one. Some fund managers take a purely long view (when it comes to portfolio management) while others take the opposing stance. A number implement a combination of long and short positions to capture both sides of market movements.
For a while now I’ve been working with a team of trading analysts to come up with some strategies that will maximise the benefits of running a long and short portfolio.
We try to share and deliver these strategies in our webinars and live seminars for traders and investors. Let me share some of the findings of this team on implementing a long and short strategy.
Firstly, one of the main reasons that we trade long/short is in an attempt to reduce portfolio volatility whilst at the same time trying not to have too adverse an impact on the overall portfolio performance.
For many hedge funds they generally look to outperformance of a specific benchmark as one of their key measures which is referred to as alpha.
Generation of positive alpha (better than benchmark) is something that we should all be aware of because if our performance for the year is positive but short of the benchmark (for instance a share market index) performance then we need to look at improving the returns.
Needless to suggest that if you are going from a portfolio of long only positions to a mix of long and short positions you will likely see a change in the behaviour of your portfolio.
For starters, carrying a mix of long and short will not automatically defend you from downturns in the market. Possibly you may not get the full benefit of upswings in the market with this being particularly evident on days when there is a great big jump in the market during a single session.
Whilst this in itself may be frustrating, the thing to keep in mind is how your portfolio performs on days when the market doesn’t shift sharply one way or the other which is what we see on average.
It should be noted here that so far this year we have seen a significant increase in the level of average daily range that the S&P/ASX covers which is really what is characterising the volatility at the moment.
As I mentioned you can’t expect a selection of short positions to automatically give you a portfolio that will be defended if there a sharp negative move.
From an anecdotal perspective big swings downwards on the market at large often see the biggest selling from some of the best performing stocks in the market. As I say that is only my own anecdotal experience and is not a unified rule of the sharemarket.
I would suggest that a possible reason why this might occur is because if people have floating profits in companies and then there is a big negative move in the US overnight you would imagine that people will be queued up to sell out as quickly as possible in an attempt to lock in their profits.
On the flip side though people who are holding stock that may already be downtrodden are possibly not as likely to rush to the sell button because they are less likely to have as much short term floating profit that they want to defend.
In fact you may often find that depending on the severity of the overall market fall that some of these companies may actually attract a bit of buyer attention and send the price higher.
It’s for reasons such as these that having a 50:50 long/short portfolio doesn’t automatically give you protection in a market fall. When you think about it this should be pretty plain to you anyway because when it comes to a point where you believe that you are going to get a free lunch then you have almost certainly misjudged the risk that you are exposed to.
I think that it is important for all CFD traders to give consideration to maintaining at least a portion of their trading exposure to the short side of the market all of the time.
What I would suggest is that you don’t necessarily try to switch your exposure to the long and then the short side depending on market conditions because timing the switches is likely to yield you a pretty ordinary result.
For this reason I believe that the most reasonable solution is to be carrying long/short exposure all the time. It is unlikely that you will be 50:50 biased because there will likely be a prevailing trend in the market that you will be weighted toward.
However you should take a look around for up and down trending stocks and look to balance yourself a little more than you may be now.
I can only stress that you test out this type of strategy before you place money on the line. Although I generally put little credence in the benefits of paper trading its worth looking at how this type of strategy is likely to behave.
For a lot of traders the idea of testing a strategy is to determine how much profit the strategy would have generated but I would suggest in this case spend the extra time looking at how a dummy portfolio of trending stocks would have behaved on days when the market rose sharply, fell sharply and was pretty benign.
Then spend some time looking at how the long side and the short side performance compared to each other in terms of profits and volatility. It’s only by spending the time on strategy that you can get an idea of how things are likely to behave in reality.
Despite the fact that spending time in front of the charts is not always the most exciting thing it can do a lot for you when it comes to confidence in your methods.
David Land is CMC Markets Chief Market Analyst, with over 10 years experience analysing and reporting on the industry.
