Long and Short
Why trading can lead to baldness.
The concept of betting on prices falling is not really that complicated to understand, so long as you ignore the mechanics behind selling something that you don’t own. The risk however is quite a different story. Remember, when you buy something at 10 and it goes to zero, you can only lose what you put in. If you are short at 10 and it goes to 100, you could lose a lot of your hair. The point is, being both long and short in equal measure at the same time can create a market neutral trade.
On the face of it, having no exposure to the direction of the market can reduce risk. How much has to do with correlation. The more likely two instruments have moved in the same direction in the past, the lower the so called “value-at-risk”. Say, the market drops by 50%, but both your long and short also go down 50%, then you have lost nothing. So far so good, but what is the catch? Timing mostly. If you thought it was difficult to take a view on one thing, imagine having to take another view on something else. More importantly though, both views have to come good at the same time. The classic example is buying BMW because it is cheap and selling Daimler because it is expensive. Well, what if BMW stays cheap whilst Daimler gets more expensive? It is why trading on fundamentals is so difficult.
Of course, we can also trade on technicals, which means we are looking for specific inflection points when the ratio of one price to the other is going to go our way. Reason being, that one security may have gone down a lot and is oversold, thus poised to rebound, whereas the other side of the trade has the opposite characteristics. So called quantitative analysis can help us identify the exact time when such a trade would seem opportune. The advantage versus our former example is that we instantly know when we are wrong, and cutting losses is the first rule of any good trading strategy.
Time really is money when it comes to putting on market neutral trades. Most of that has to do with the cost of borrowing securities to go short. Just like anything to do with lending, people will charge you money. Moreover, some securities are more expensive than others as a function of supply and demand. Clearly, the longer one stays in the trade waiting for things to happen, the more expensive it is to hang on. Finally, a word of caution. It can happen that the people lending us the securities will want them back in an instant, which then forces us to close our trade. If we are not the only ones doing the same thing, it can result in so called “short squeezes”. Those can be very nasty indeed and cause us to lose even more hair.