Hedge fund strategies: Long short 2 | Finance & Capital Markets | Khan Academy

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..

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