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Investing in a long position is an excellent way to expose one's portfolio to the upside inherent in a well-selected investment. Value-driven investments made by Warren Buffett illustrate this, and the largest publicly-traded investments made on behalf of Berkshire Hathaway (BRK.B) can be seen in the company's annual reports. If, like Warren Buffett, you are in a position to invest "forever", simply buying good businesses at apparently-attractive valuations is a wonderful and low-overhead investing strategy: you pay a transaction fee once, then sit back and enjoy decades of returns!

But what if your investment horizon necessitates some control of exposure to the risks associated with unpredictable market fluctuation? Suppose you would like some protection from beta (volatility) while you are seeking alpha (active return on investment)? For an example of two stocks with different likely alpha, consider an intra-day chart from Google Finance, depicting the two tickers featured in "Apple: The Long And The Short Of It":

(click to enlarge)

An investor in either Apple (AAPL) or Research In Motion (RIMM) on Friday, April 13, 2012, would have suffered losses exceeding 2% of the entire position before lunch. By the end of the day, each was down about 3%. Losing 2% in a single trading day is equivalent to an annualized return of approximately -99.5%. Do you really have the stomach for this? Does your spouse?

Of course, a long-term investor can potentially tolerate this sort of result with the patient confidence that (to paraphrase Warren Buffett) although the markets are in the short run merely a popularity contest, they are in the long run a weighing machine that will over time prove out a solid investment thesis. But suppose you expect to need money for a child's education in five or ten years. Or your retirement is approaching, or you plan to move and need a downpayment on a larger home. Are you forced to pass up opportunities like Apple simply because they are too volatile to tolerate on a day-to-day basis? Remember, since 1999 Apple has had days in which it lost 50% of its value in a single day. When you run out of Maalox, will you have to dump your shares?

It's not hard to imagine an investment opportunity that has an expected return in a 5-year period, and from which you expect to want to exit in less than 10 years - making it impossible to follow Buffett's example. Must you forego the investment, despite your conviction, simply because markets are fickle over short periods?

It is certainly possible to protect against downside through the use of derivatives, but the premium on a put option is directly related to volatility: buying insurance against a volatile holding's downdraft risk will consume profit-killing resources over time. How can an intermediate-term investor afford to protect against these risks?

Using Long/Short As A Hedge

In the absence of company-specific news, firms in similar industries tend to move in tandem with one another for the simple reason that their fortunes are - barring firm-specific factors - dependent on the same customers, suppliers, advertising intermediaries, and so forth. News that effects the industry's customers, suppliers, advertisers, or regulators will result in similar pressure (or relief) to similarly-situated firms. An investor long on Apple would have suffered a loss in the market on April 13, 2012; but an investor with a long/short position in which Apple holdings were matched with equal-dollar short positions in Research In Motion would have experienced much less volatility: subtracting the blue and red graphs in the above chart yields a lot less room than between either graph and the zero line. On that day, in fact, the investor would have been marginally up.

This strategy does not facilitate profit from an updraft that improves the fortunes of every player in an industry, or lifts the entire stock market indiscriminately. From the date the author opened a long/short position in +AAPL/-RIMM, Google Finance shows definite similarities in the shape of the stocks' graphs for much of the period, but significant differences in where the tickers have landed to date:

(click to enlarge)

The strategy is well-adapted for the situation in which two firms share similarities about which the investor is uninterested in making an investment, but have differences that make one stock a superior investment to the other. In the case of Apple and Research In Motion, the advantages of Apple are laid out in the above-linked article. It's important to note that the shorted ticker need not lose value for a long/short to be profitable: it need only fail to perform as well as the long leg. Research In Motion has an interesting story as a potential long-term investment. Likewise, the long/short enables profit when both firms plummet - as in the intra-day chart above - provided that the long leg ultimately plummet's less. The graphs depict shares of firms competing in the mobile device industry, but the logic can be applied in any industry.

Suppose one had developed a thesis that refining would prove a low-margin business that would fare poorly with comparison to petroleum infrastructure and production, or to the profits available to integrated petroleum companies. To invest in all aspects of the petrochemical industry except refining, or to invest in a thesis that refiners would underperform integrated petroleum enterprises, one might select a fully integrated petrochemical firm with attractive management characteristics, and match it against a short position in a firm whose principal operations consist of refining. One can pick an industry segment to single out for investment (or shorting), a specific management team, or any other factor the investor is able to identify as a distinguishing characteristic. The key is finding an investment pair that adequately contains the elements in which the investor wishes to invest, and against which the investor wishes to control.

Long/Short vs. Options, Stop-Loss, etc.

Unlike options, which are short-lived and cost more with increasing volatility, a long/short investment is as cheap as each equity trade regardless of volatility and does not expire until exited. The ability to use similar-industry peers as "controls" against unwanted beta can help investors to target the characteristics in targets companies most likely to produce alpha - either in the upside, or the downside. Because there is no periodic premium, the long-term cost of the strategy can be much lower than hedging with options. The investor must identify well-matched firms to enjoy good beta elimination, but by selecting index funds it's possible to invest in a company's relative performance to an index as opposed to an industry peer. This may be useful when one is uncertain which companies will succeed but certain which will do poorly (one might take this view of Nokia (NOK) as a commodity handset vendor), or when investing in a company for which one has not identified a comparable industry peer that is different in ways that encourage a short.

Although trailing stops are sometimes described as offering downside protection, investors are urged to consider that even really attractive long-term investments can be difficult to hold with closely-trailing stops. As volatile as Apple has been over its run following the return of Steve Jobs, consider American Capital Ltd. (ACAS) from the month the author last bought it (excluding DRIP reinvestment in 3Q2009):

(click to enlarge)

How would one expect to hold so volatile an investment with a trailing stop close enough to offer reassurance? What transaction fees would be incurred repeatedly re-establishing an investment? How much time would be consumed watching each investment like a hawk, struggling to move trailing stops and trying to guess the right place to put them?

Conclusion

A well-matched long/short position can offer protection against beta without risking the tax-inefficiency of repeatedly trading in and out of investments on the way up, or the overhead of purchasing repeated options positions. Moreover, long/short positions enable profit even in completely down markets, because positions need not do better than zero, they need only do relatively better than the paired investment.

Source: Investing Long/Short To Manage Volatility In Apple

Additional disclosure: The author has been short RIMM as part of a long/short position entered while the article "Apple: The Long And The Short Of It" was pending.