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Studying for a test? Prepare with these 5 lessons on Investment vehicles, insurance, and retirement.
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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.