The long short strategy is one that has been used by hedge funds for a time, and is designed to succeed whether the market as a whole goes up or down. CFDs are an efficient way to take positions on share movements, so the long short CFD portfolio can make good use of your trading capital.
In its most basic form, the long short strategy is very simple, although you can add as much complication as you want. You can apply it to the market as a whole, for example to the FTSE 100, or you can select just two companies in a certain market sector and use the long short strategy to trade them. What you need to do is enough analysis to see which company is the stronger, and which is weak. You then take a long position with the company which is expected to do well, and a short position on the failing company.
ou would expect to make money on both of these positions, if the market stayed in a neutral stance. The long short strategy wins even if the market as a whole goes up or down, as it is the relative strength between the two that is giving you your profit. If the market goes up, the long position makes more profit, and the short position may make a small loss; if the market goes down the long position loses, but the short position should profit more than the loss, giving an overall gain to your portfolio.
Long/short CFD portfolio construction: you take say the FTSE 250 and buy the best performers and sell the worst performers. You can refine it by instead of buying long/short in equal proportions you buy/sell in proportion to the market breadth. So if 70% of stocks are above the 200 moving average your proportion of Longs to Shorts is 70:30. How hard can that be – you’ve got your own hedge fund…
There are some variations to this simple application of the long short strategy. For instance, as mentioned above, you can apply it to the entire market, choosing strong stocks for the long position and weak stocks for the shorts. This diversifies your portfolio, so that if you are on the wrong side of any particular stock the effect is minimal. One way to assess the strength of stocks is to determine whether they are above or below the 200 day moving average. If above, then the stock is performing well, and if below then the stock is showing signs of weakness.
While having equal amounts of long and short positions makes your portfolio neutral with regard to overall market performance, some traders prefer to have a bias in line with the overall market. If the market is behaving strongly, with perhaps 80% of the shares showing strength, you would take a long position in those and a short position in the remaining shares. This is a balance between trading for the strength and hedging against market movements.
One thing I noticed is how the media tend to single out Buffet and Bolton but rarely mention John Templeton who traded long/short with an average 27% annual return throughout his fund life. I bet there are thousands of UK investors who have done much better than the professionals in % terms but have the benefit of using smaller capital holdings and much fewer compliance constraints.
While the long short strategy is efficient at hedging overall market performance, it depends on your stock picking abilities and so does not avoid the work involved in analysis. It is a type of pairs trading, where you pick the best and worst performers in a market sector and enter trades appropriately. However, with the large swings in overall markets that we have experienced in recent years, it is a strategy worth considering.
Practicalities: Narration of a Trader
I’m currently using my Longs/Short strategy to trade my shares portfolio although I don’t use all my wealth capital to trade shares. I hold 50% in fixed income and 50% in shares. Equities are split into ‘Long Term shares’ and ‘Medium Term CFD holdings’.
To be invested 100% in the Longs/Shorts portfolio is quite easy with little emotional stress but requires a fair bit of effort. If I hold say 20 long positions and 10 short positions while the markets are trending up my longs should do very well and my shorts will do OK but nothing startling. If the market has a big down day or a major retracement my short trades tend to be stunning while the longs generally pullback. It means I can be fully invested with wider stops than I would otherwise be comfortable with. It also means I can hold wider stops with less drawdown. If the market actually reverses into a downtrend I have a head start with my short positions as the long positions get stopped out. Well, that’s the theory but it’s still early days.