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#1
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![]() Recently, there's been some discussion here of the state of the stock market....
If you think the market may be lurching up and down, there's still an investment strategy that could help.... It's known as a "market neutral" strategy.... Here's how it works. Let's say, for example, that you want to invest in pharmaceutical companies, and you think that Pfizer (PFE) stocks will do better than Merck (MRK) stocks. (This is just an example to illustrate the investment technique - I haven't actually done any analysis of these companies....) If you think Pfizer will do better than Merck, then you can buy Pfizer stocks, and short sell Merck stocks. Short selling means that you, in effect, borrow some stocks of Merck to sell at the current price.... You may then have to buy Merck stocks later (if you get a margin call), at the price it's at on that date, to return the stocks you "borrowed".... If the price of the stock goes down, then you make money (since you sell the stock high, and buy it low), but if the price goes up, then you lose money by short-selling (since if the price goes up, you end up selling low, and buying high).... Anyhow, by using this combination of buying one stock (the stock you think will do better), and short-selling the other stock (the one you think will do worse), you have a market-neutral strategy. That means, you'll make money based on the relative performace of the two stocks, and how the market behaves overall won't affect your return.... For example, let's say that the stock market crashes, and both Pfizer and Merck stocks go down by 50%. Well, you'll lose money on Pfizer because of this (since you bought the stock), but you'll make money on Merck (since you short-sold it) - so it will have no effect on your total profit. Similarly, let's say the market soars, and the prices of both Pfizer and Merck double. In that case, you'll lose money on Merck (since you short-sold it), but you'll make money on Pfizer (since you bought the stock). Again, the total effect of the market has had no effect on your profits. The only thing which will affect your profits is how the two stocks move relative to one another. If Pfizer goes up more than Merck does, then you'll make money - since you bought Pfizer stock, and short-sold Merck. But if Merck goes up more than Pfizer does, then you'll lose money overall. This is one way you can invest in the stock market using a "market-neutral" approach.... If the market swings up and down - as long as it affects your two stocks about equally - it will make no difference to your return. (Thanks to my brother Thomas, who I learned this from....) I hope that helps someone.... Just because you're worried about the fluctuations in the stock market, doesn't mean you can't "protect" yourself from them, and still come out ahead! - Dien Rice |
#2
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![]() If I buy stock I think will go up and short stock I think will go down, and if both of those things happen, won't I be in the same place I started at?
If I have $2,000 and buy $1,000 of stock to hold and $1,000 to short, and if they both go their own ways at 10% (my hold stock is $1,100 and short stock is $900), I still have $2,000. What's the point in doing that? If both stocks dive at 10%, the $100 I lost on my hold stock is paid back by the $100 I made on the short stock. And vice versa when the stock goes up. I am no better - or worse - off. Wouldn't it be better to buy "loss insurance" so if your "buy and hold" stock goes down, you get $X back instead of wearing the loss and trying to make up for it on another stock? Just use some of the money you would have used to short stock to buy your "insurance." Michael Ross |
#3
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![]() > If I have $2,000 and buy $1,000 of stock to
> hold and $1,000 to short, and if they both > go their own ways at 10% (my hold stock is > $1,100 and short stock is $900), I still > have $2,000. Short-selling is like borrowing stock and repaying it back later. In the case above, you've borrowed $1,000 but only need to repay $900, but since you've sold the stock you've borrowed, you haven't realised that $100 loss and thus it is a $100 gain. The transactions would look more or less like this: Beginning Position: $2,000 cash Transaction: Buy $1,000 ABC Corp, Short Sell $1,000 XYZ Corp New Position: $1,000 ABC shares, $2,000 cash, $1,000 XYZ Corp shares owing to somebody (You have $2,000 cash because $1,000 you didn't end up spending, and you receive $1,000 when you sell those shares you borrowed. You don't really "spend" money to short sell, but you do require margin to protect the broker if positions move against you.) Event: ABC Corp becomes worth $1,100, while XYZ goes to $900. New Position: $1,100 ABC shares, $2,000 cash, $900 XYZ shares owed to somebody If you close out the position now, you'll have the $1,100 from ABC shares, plus the $2,000 cash, minus the $900 to repay, or $2,200. Now, what Dien was talking about is a market neutral strategy where the long and short positions are "matched" to some degree to protect against general market or sector movements. The idea is that the two stocks you choose to go long and short in will move together somewhat based on changes to the entire economy, or changes to the sector. If the two stocks are matched sufficiently well, this should leave you with more individual security risk. That is, you're mainly exposed to how your securities perform relative to eachother, rather than overall. So to take your example again above, let's say that ABC and XYZ are related, and you buy $1,000 ABC and short sell $1,000 XYZ. Then let's say that a terrible earthquake hits the US, and this affects most stocks, and ABC and XYZ both go to $500. After this "shock", ABC rises to $550 (due to being a superior company overall), and XYZ stays at $500. What's your position if you just went long in ABC, your favored company? You'd basically invest $1000, and have it drop to $550, losing $450. If you go long ABC $1,000, and short XYZ $1,000, then your end position is... $550 ABC shares, $2,000 cash, $500 XYZ debt, or a net position of $2,050. So there's the main perceived benefit. There are, however, risks people should be aware of. If you are a long-term investor, and you buy-and-hold a stock, then what really matters to you is the 5 or 10 year performance (depending on your investment time horizon), and the movements before that do not really matter. If you start taking short positions, however, these short-term movements can matter. If you short something, and it "irrationally" goes up a lot -- or you just plain get it wrong -- this can force you to sell long positions to cover your short positions. You don't have this risk if you just go long. :) Hope this clears it up a bit! Best Regards, - Thomas. |
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