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Hedge fund strategies: Long short 1

Setting up a simple long-short hedge (assuming the companies have similar beta or correlation with market). Created by Sal Khan.

Video transcript

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.