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Hedge fund strategies: Long short 2

Seeing how the long-short portfolio might do in different market conditions (assuming that the underlying thesis is right). Created by Sal Khan.

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  • female robot grace style avatar for user trovial
    are hedge funds called like that, because they always hedge their positions?
    (5 votes)
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  • blobby green style avatar for user env5002
    Is the key to this strategy investing equal dollar amounts in each stock? (in this case buying $10 worth of stock in each co.)
    (3 votes)
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  • blobby green style avatar for user ktiwari.02
    Is it a good assumption at that if market goes up, share price of companies A & B will also necessarily go up? Or, at that if market goes down, share price of both will necessarily go down?
    (4 votes)
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  • blobby green style avatar for user Anthony Musiani
    Would companies A and B typically be in the same industry, or is it also common to place a long short between two entirely different companies?
    (3 votes)
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  • leafers seed style avatar for user Alec
    This questions is extremely simple... How can you "short" or sell a stock which you do not own? Is taking a short position on a stock sort of like you claiming that stock with the expectation that it will not be successful?
    (1 vote)
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  • blobby green style avatar for user fede.grosso8
    Does a scenario exist where both companies exceed my expectations?
    (1 vote)
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  • piceratops ultimate style avatar for user Baron rojo
    when you buy and sell stocks you always find a buyer and a seller? or you need to wait for offers?
    (1 vote)
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  • female robot ada style avatar for user M Brown
    Is there a legal connection to long-short stocks? I mean, if you sell one kind of stock and buy another is that automatically long-shorting them? Or is this a particular kind of hedge fund that creates a connection between the two? I'm missing a key connection point here.
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      Long-short just means that you are doing both buying and short-selling. The result of this is that your exposure to aggregate moves in the stock market should be lower than it would be if you only were selling. You can in principle get to 0 market exposure by shorting exactly as much as you buy. If you do that then (in principle) all of your investment return will come from the outperformance of your longs relative to your shorts.
      (1 vote)
  • piceratops seedling style avatar for user huiyike0408
    Why this long short strategy called hedge fund strategy? is this strategy exclusively used by hedge fund only?
    (1 vote)
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  • leaf green style avatar for user George
    Hedge funds are called hedge funds because they generally involve a group of people trying to hedge money out of the market and into their control? Or are they called hedge funds because you are trying to hedge out the market risk? Even if all you did was short sell, wouldn't that still be a hedge fund?
    (1 vote)
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    • male robot hal style avatar for user Andrew M
      There really is no meaning anymore to the word "hedge" in hedge fund. Way, way back the first hedge funds were called that because they were supposed to hedge out most or all of the market risk. Some hedge funds do that today, but the name has broadened so much that it now includes basically any private fund that charges performance fees.
      (0 votes)

Video transcript

In my attempt to have a portfolio whose performance should depend only on my ability to identify good companies, and to identify bad companies, and not be held sway by whatever the market might do, I have bought a share of company B, thinking that it's a pretty good company and will do better than expected. And I have shorted two shares of company A. And I've shorted two of them, because they're only at $5 a share, and I wanted to short the same dollar amount. So now I want to think about, assuming that I was right, that company B will do better than company A relative to each other, how my investment will do if the stock market moves up, or if the stock market moves down. So let's imagine a situation where the stock market moves up. In that situation, you could imagine both of these stocks will go up. So let's say company B goes up in percentage terms more than company A. So let's say that company B gets to $15. So it gets to $15 a share. So it is up 50%. And let's say that company A only goes up by 20%, so it goes to $6 a share. So in that situation, what happened? I clearly make a lot of money on company B, on my long position, when the stock market goes up. $10 became $15. So I made $5 there. And I clearly lost money on my short position, because I sold it at $5, and now I'm going to have to buy it back at $6 if I want to cover my short position. So this $10 position-- remember, I have two shares of them-- are now worth $12, 2 times $6. And since this is a short position, I will lose $2. But because the company that I thought would do better did do better, it went up by 50%, while this only went up by 20% percent, I still make money. I still make a $3 profit. Now let's think about what happens if the whole stock market goes down. And I'm going to assume that I'm good at picking the right companies. So I'm going to assume that my thesis holds, that B does better relative to A. So let's say in this negative scenario, B goes down by 20%. So it gets to $8 a share. So this is the market up, this is the market up scenario. Now let's imagine the market down scenario. So now my position in B goes from $10 $8. So I lose $2 on my long position. But when the market went down, I was right, A is not that great of a company. So it goes down more. Let's imagine that it goes down by 50%. So A goes down by 50% all the way to $2.50 per share. So my position in A, the short position that was $10, it is now a $5 short position, two shares at $2.50 per share. So this is a short position. I sold the stock, I borrowed and sold it $10. Now I can buy it back at $5. I make $5 on the short position when the market goes down. So even though I lost some money on my long position when the market goes down, I more than make up for it on my short position. So even in the down market, assuming my stock picking is good, I have still made $3. And so what we've set up here is a long short hedge. And what's cool about it is, it's only dependent on the investor's ability to differentiate between companies that are more or less likely to do well relative to other companies. And it's not as dependent on someone's ability to pick which direction the market itself will be going. And so when people talk about long-short hedge funds, they're talking about hedge funds are essentially doing this. They're trying to hedge out the market risk.