Hedge funds follow unique strategies of trading in the market. Equity long short strategy is one of them. As the name suggests the strategy takes long positions in those stocks which are expected to rise and short positions in those stocks which are expected to fall in the market. So, the hedge fund or the hedge fund manager applies this strategy to buy undervalue stocks and sell overvalue stocks in the market.
An equity L/S strategy can be applied to a sector, country and region specific area. In general, the hedge fund manager makes profits by keeping the healthy margin of spreads between long and short positions. Lets say, a hedge fund manager buys $1 million of Apple shares and sells $1 million of Nokia shares at Nasdaq, thinking, the upcoming event at Apple’s WWDC meet will lift Apple’s shares in the market and might impact the shares of Nokia (so going short on it). Imagine, if the manager has made perfect call on both the stocks – going long on Apple will fetch profits and going short on Nokia will give profits as well. But if the manager misses the call then what? So, consider another situation where both the stocks rise due to some event/news . In this case, the manager has to make sure how he/she has allocated money for these stocks. It depends if the manager was using “130/30” strategy i.e. 130 percent exposure to long position to long and 30 percent exposure towards the short position i.e. long bias, this formula is purely up-to the manager to decide some even take 120/20 equity L/S. In the above mentioned case since both the stocks were from the same sector, this kind of trading is also known as “pairs trading“. Overall, this strategy works when the manager predicts a perfect call.