Spreading the Wealth – Spread & Long/Short Strategies

“One of the principal risks is that both the long and the short positions move against the investor; this could produce even greater losses than simply being long or short”

By Michael Moretto, Contributor

The magnitude and speed at which financial innovation has occurred over the past thirty years is nothing short of astonishing. Increasingly complex financial products give investors the flexibility to implement more complex investment strategies.

Accordingly, it is impossible to find the ‘perfect’ investment style or strategy; rather different strategies cater to different levels of investor sophistication and goals.

Before trying to decide on a particular investing style, one must consider his own particular risk tolerance, time horizon, investment objective, need for liquidity and so on. Investing in a financial product with an initial lockup period might provide an excellent risk-adjusted return; however, it would be completely inappropriate for an individual that needs unobstructed access to their funds.

Market leaders are companies that are expected to show more potential than their peers or the market and possess a position of dominance compared to the offerings or market position of their peers. The opposite can also be said for companies that are ‘underperformers’ relative to their sector, industry and index.

This is where the concept of a spread trade comes in.

In any given sector, an investor can select what they think to be the leader(s) and underperformer(s) and exploit the spread (difference) between them. This would be achieved by going long the outperformer and short (i.e. short selling) the underperformer.

In an ideal situation, profit would be achieved from the leader generating positive returns and the lagger producing negative returns, thus returning a profit on both the short and long positions.

The same logic could be applied to a sector and either a strong/poor company within that same sector. For example, with a negative outlook on the sector, one could short it and long a market leader. The logic being that even if the market leader and the sector both fall, the market leader will fall less than the overall sector. This means that the short on the sector will return more profit than the loss will be on the market leader, leaving the investor with an overall positive return from the combined two positions.

It goes without saying that there are risks with this investing style. Some are more specific to this style whereas others that apply generally to investing.

One of the principal risks is that both the long and the short positions move against the investor; this could produce even greater losses than simply being long or short. Proper risk management measures, such as a stop loss on the long position and a limit buy on the short position, will help to limit the extent of losses.

Another risk for a trader could be a break from a historical relationship that exists between a pair of securities. A break in these traditional trading bands, ranges in which securities trade, can be caused by moments of market panic or euphoria. This in turn can be problematic for investors with a long/short spread trade, because the two securities are out of their normal trading range and may not respond in the predictable way the investor expected.

A matter of moments is all that it may take to break a historical relationship that has existed for such a long period of time and that we have almost taken for granted. This reliance on empirical observations is not unique to this particular investment approach; however, this investment style is susceptible to this type of problem.

By Michael Moretto, Contributor

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