What are the benefits of doing long short trading rather than long-only?

Long-Short Trading vs. Long-Only Trading: Which is better for you?

If you’re investing in the stock market, you have two basic choices when it comes to what types of investments you want to make: long-only and long-short. In this article, we’ll take a look at both types of investing and determine which one might be right for you!

Comparison Between Long-Short and Long-Only

Similarities and Differences If a market (or asset) goes up over time, long-only traders make money—but not as much as long-short traders do. Long-short traders are able to capture more profit from a rise in a market because they bet on both price increases and decreases, or go long on what’s going up and short on what's going down at any given time. 

The short position offsets some of the gains from their long positions; if an asset declines in value, then they lose less than investors who only buy assets that are expected to rise in value. Long-short trading also allows for leverage, which magnifies returns. When a trader buys $100 worth of shares with borrowed funds, he gets $200 worth of stock to trade with. 

In other words, he can control twice as many shares with his capital. Leverage can be used to increase profits but it can also lead to greater losses if things don't work out according to plan. For example, let's say someone invests $1 million into 10 stocks using long-only trading, and each stock rises by 10%. After one year he has made $100,000 -- not bad!

Better Returns on Investment

So let’s look at two strategies that were applied by two traders in recent times, a long-only trader (Mr. Wannabe) and a long-short trader (Mr. RealDeal). Mr. Wannabe borrowed $10,000 and bought 100 shares of ABC stock at $100/share. Six months later, he had made $600 and sold his stocks when they hit $110/share for a grand total of $11,600 in profit (not including fees or interest charges). 

Great job! Now let’s look at Mr. RealDeal; he also borrowed $10,000 and bought 100 shares of ABC stock at $100/share like Mr. Wannabe. However, he also shorted an equal amount of XYZ stock at $50/share because it was overvalued. 

In six months, Mr. RealDeal lost $200 on his short position while making a whopping $7200 on his long position with ABC stock—for a total profit of almost $9000! What gives? Why did Mr. RealDeal make more money than Mr. Wannabe despite borrowing twice as much money to start out with? 

The answer lies in what happened to both stocks after six months—ABC went up 10% while XYZ went down 10%. The result was that Mr. RealDeal earned 15% on his investment while Mr.

Lower

While long-only investing means investing in just one stock, long-short trading allows you to actually be invested in both long and short positions simultaneously, greatly reducing your . 

If a company makes an announcement that causes their stock to plummet while other companies stay level or rise, as long as it's not catastrophic, you'll actually see your portfolio's value rise because of your short investment with your broker. 

In a way, you are protected by both sides of the investment. It would be like owning a restaurant and getting half of your revenue from dinner sales and a half from drinks; if dinner sales plummet but drink sales remain steady or increase (don't underestimate happy hour!), your overall business will still do well despite dinner sales being down.

Customized Approach

One of the long-short trading’s biggest benefits is that it can provide an opportunity to diversify and create a more customized approach to your investments, rather than using one blanket strategy for all of your investments. 

If you have a long-only portfolio, many factors determine its performance; one factor that plays an integral role in deciding whether a fund will perform well or poorly at any given time is market conditions. Because market conditions are always changing, a long-only portfolio can perform very differently from year to year, depending on these conditions. 

For example, if you had a long-only portfolio during 2008 when markets dropped precipitously and investors lost trillions of dollars worldwide, your returns would have been dismal. 

However, if you had invested in a combination of stocks (the ones) and bonds (the safer ones), your returns would not have been as affected by market conditions because both types of investments would experience gains and losses simultaneously—and likely offset each other—when markets were down. 

Thus, even though there were still losses in 2008 with such an investment strategy (because some stocks performed badly), they were less severe than what could be expected with only stock holdings.

Guaranteed Results

That’s what a long-only portfolio will give you—guaranteed results, with lower volatility and much less  than shorting or hedging your portfolio. The average long-only investor will have a very smooth ride, with modest gains that are usually fully captured in good years and recovered from bad ones before too long. 

A long-short trader can expect both benefits of lower volatility and higher returns, but because these returns are leveraged by taking on  from shorting stocks and maybe hedging those shorts with options, there’s also an increased chance of losing money; investors should expect far more negative years than positive ones as well as larger losses during those down times when compared to a long-only portfolio.

Conclusion

When deciding on a trading style, it can be hard to determine which investing method will benefit your portfolio more. For some traders, long-only might offer them peace of mind and stability; other traders may prefer to take calculated and reap higher returns from shorting stocks that appear overvalued or overbought. 

Ultimately, we all have different investing needs and tolerances, so if you’re still trying to decide between these two styles, there’s no wrong answer! Just like with anything else in life, there are pros and cons to every type of investment—but if done right, both long-only and long-short trading can help you grow your portfolio over time. It just depends on what kind of investor you want to be. 

Have a good day!