Take the time to look into what is an actual long-short strategy and you’ll see that it’s a common theme used by hedge fund managers to hedge a decision to be short on one company, and be long on another.
Historically, high volatility in markets is the time to move to cash, and sit it out and wait. In the past these moments have been averaged out to an occurrence every five to seven years, however since the introduction of the covid pandemic, we’ve seen volatile markets twice in the past two years. Several factors have contributed to this, such as the uncertainty of the pandemic and its effects on our global economies, a credit induced recession brought on global reserve banks, and of course the effects of high inflation from financial mechanisms introduced during the pandemic.
If you were to take the ASX200 for example, and look at its long term chart over 30 years, you would see a ‘business cycle’ (growth, correction, recovery) occurring every five to seven years, yet look at that same index from 2019, and you’ll see what appears to be two of these cycles in short space of time.
If you were to take the time to review these large drops in the market you’ll see some fairly interesting behaviour, day in – day out, you’ll see some days where the market has declined, falling down to an eventual bottom before a recovery occurs. A time where in hindsight many people will say things like, ‘I wish I got out back there’. Well, what you’ll also notice on the path down to the bottom are some points where the indices are green. These are called ‘retracements’.
Take for example the 25th of August, 2008. It was a Monday, it was also the beginning of a week, mid GFC market crash. In October 2007, the ASX200 had begun its journey from $6,645 on a 52.9% drop to its bottom at $3,126 in March 2009. However, this last week of August in 2008, the market saw a slight breath of air.
Its with these retracements, that we can formulate a strategy to use this extra market volatility to our advantage.
Take the time to look into what is an actual long-short strategy and you’ll see that it’s a common theme used by hedge fund managers to hedge a decision to be short on one company, and be long on another. Being short a company is where you borrow the stock in a company, sell it a higher price, expecting it to decline in value so that you can buy it back at a lower price, and return the borrowed stock to the owner. Being long a stock, means you’ve bought that stock at a price, expecting it to increase in value, this is considered the standard way to invest in equity markets. Hedge fund managers who have for years utilised a long-short strategy will research companies they feel are overvalued, and feel will drop over time, and short those companies, but they will hedge those bets against similar companies they feel are undervalued and will rise in stock price over time.
Now if we are not hedge fund traders and simply investors watching markets hoping to grow our wealth slowly over time. These periods of extreme volatility will have traditionally had people moving their hard-earned savings from equities into the bank account to wait and see. However, with expected volatility on the horizon, how can we use this volatility to our advantage.
Given that most of us are not hedge fund managers, we don’t typically have access to derivatives, nor do we have the research capabilities to analyse endless pages of data to find a series of companies we feel will rise and fall over time, especially during an erratic market. However for a somewhat sophisticated investor, what many people can see is a horizon where indices may be going to fall.
There is a raft of mechanisms which can be utilised to profit during a period of falling indices, and those are available to most investors. The investment menu for short or bear exchange traded funds (ETF’s) has increased dramatically in the past 7 years, and these have made the process of betting against large indices far more accessible to everyday investors, and its using these during a time of increased volatility, that allow investors to effectively make profits even in a period where markets are declining. Typically, many of these bear market ETF’s are also leveraged, so they do tend to come with added opportunity for growth, but with that also comes added risk.
Purchasing a hedge or short position when markets are high, can seem counterintuitive, however in times like now when a market is plummeting is a solid strategy to increase profit margins in tumultuous times.
Brendan Gow, a corporate authorised representative (no. 1295850) of Samuel Allgate Investments pty ltd (SAI) AFSL420170 (the “Aussie Advisor”). This article has been prepared without taking into consideration any investor’s financial situations, objectives or needs. Accordingly, before acting on the advice in this article, if any, you should consider its appropriateness to your financial situation, objectives and needs. Every reasonable effort has been made to ensure the information provided is correct, but we cannot make any representation nor warranty as to the accuracy, completeness or currency of that information. To the extent permissible by law, no responsibility for any errors or misstatements is taken, negligent or otherwise. SAI or its authorised representatives may also receive fees or brokerage from dealing in financial products, see the Financial Services Guide for information about the services offered available at http://www.ywm.com.au/.