Let's say I've been researching
some stocks to potentially invest in, and I feel
pretty good at my ability to predict how good a
company's going to do relative to people's expectations, or
the market's expectations. And in particular, I focus
on companies A and B. And in the case of
company A, I think it's going to do a lot worse
than the market expects it to do. So I'm tempted to short it. And in the case of
company B, I think it's going to do much better
than the market expects. So I'm tempted to
buy it, or go long. But there's one thing
about this process that gets me a little
bit uncomfortable. I have confidence in my ability
to pick out companies that are going to
outperform the market, or are going to
under-perform the market, but I have no
confidence in my ability to predict to the market. So in general-- let me draw
a little chart of the market, this is the market
price, maybe this is the S&P 500 or the
NASDAQ-- and I've just found that it's as good as
random, as opposed to me trying to pick out bottoms
of the markets, or tops of the markets,
and all the rest. And so my fear is, what
happens if I buy company B, based on my sound research,
and then the market goes down? Then company B will
probably still go down. Maybe it won't go down
as much as the market, but it will still go
down, and I'll lose money. Or what if I short company
A and the market goes up? Maybe company A won't go a won't
go up as much as the market, but I'll still lose money
on my short position, which is essentially a bet that the
stock is going to go down. So is there some
arrangement I can do, some combination of
buying company B, and selling or
shorting company A, that will essentially hedge
out a lot of this market risk? And as you can
imagine, there is. And I won't go into all of the
statistics of it, and beta, and you can really try to
statistically hedge out the market risk. But the general idea
is, if you really think this is going to
outperform the market, or definitely
outperform company A, and if you think A
going to under-perform the market, or definitely
under-perform relative to company B, you can
buy a similar amount of B as you will short company
A. So in this case, let's just do one share. You can obviously do
multiples of this. You buy one, let me
write it over here. So you buy one
share of company B, and you sell, or you short,
one share of company A. You borrow the
share, you sell it, you'll have to buy
it at a future date. So you short, I
shouldn't say one share, you short two shares of
company A. And the reason why I'm saying two shares of
company A instead of one share, is because A is only $5 per
share, and B is $10 per share. So I want to do roughly
the same amount. And once again, you can do
fancier statistics on it to tweak it, so you can
see how much they actually move with the
market, but we're not going to worry about
that right here. So for simplicity,
what we've done here is we've taken a long position,
let me write it over here. We've taken a long
position in B, and we have a $10 long
position, and we've taken a short position
in A, and it is also a $10 short position. Once again, because
A is $5 per share-- so we took two shares of A-- it
makes the same dollar amount. Now, and maybe I'll save
this for the next video, I want you to think about what
happens if the market moves up or down, but B outperforms
A, or A outperforms B.