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Long/Short Equity: Definition, Strategy & Examples

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, we will discuss long and short equity investments: what they are, examples of each and the different long-only, short-only, or long/short strategies that can be used.

Up-Umbrella Inc. & Down Coats Corp.

Imagine you have just spent the last few months researching investments in the stock market. You have identified two securities in particular that are mispriced. One of the companies is Up-Umbrella Inc. - a leading manufacturer of (you guessed it!) umbrellas. The other is Down Coats Corp. - a seller of down coats. Up-Umbrella's shares are selling for $50, but you think the true value of each share is $100. Down Coats, on the other hand, is selling for $75 per share and you think they are worth $25. What you want to do is bet that Up-Umbrella's share price will increase and Down Coats will decrease. You have been reading about different long/short equity strategies. You just aren't sure what strategy to use. That is until you read this lesson.

Defining Long and Short Equity

Let's 'break apart' the term long/short equity. We'll start with the word equity which also means the stock of a company. These shares are publicly traded in stock markets, like the New York Stock Exchange. Now, long/short refers to the position an investor takes in the stocks. A long position means you bought the stock with the anticipation that its market value will increase. A short position is the exact opposite. You sold the stock expecting its market value to decrease. In the example above, you would 'go long' Up-Umbrella Inc. and short Down Coats Corp.

There are a few different strategies that can be employed with long/short equity investments. We'll go over the three most common examples.

Long-Only Strategy

A long-only strategy means you buy the stock with the anticipation that it will increase in market value, and once it does you sell the shares to realize a profit. A long-only strategy is when you only invest in long positions. So even if a stock is selling far above your perception of its true value, then you would not short that stock. You would simply ignore it, and focus on buying shares that are undervalued. A long-only strategy using our example in the introduction would be if you bought Up-Umbrella Inc. at $50 in anticipation that its market value will eventually equal its 'true' value (in your eyes) of $100 per share. For example, if you bought 100 shares at $50, you would pay $5,000. If after a few months, everything goes well, you will sell those 100 shares for $100/each earning $10,000. Your net profit for the trade is then $10,000 - $5,000 = $5,000.

Short-Only Strategy

A short-only strategy is the exact opposite of a long-only strategy. You sell the stock because you anticipate its market value will decrease. The mechanics of this transaction are a little bit more involved than the long-only strategy. We'll use the example in the introduction. Because you think Down Coats is overvalued, you will short it. You will borrow Down Coats Corp's shares from a brokerage house. Let's say they lend you 100 shares. You will then immediately sell those shares at $75 and receive $75 x 100 shares = $7,500 in cash. As time goes by, eventually you will need to give the brokerage house back the Down Coats shares that you borrowed. At that time, if all goes well, you will buy Down Coat shares back in the open market at a lower price, like $25. You will then spend $25 x 100 shares = $2,500 to buy back those shares. In total, you received $7,500 and paid $2,500, so your net profit for shorting Down Coats shares is $5,000.

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