Does it make sense to have both long and short positions in a portfolio?
So far I've only been buying stocks long and selling them to take out profits within a few days or weeks. Today when the market was tanking I put some money in a bear ETF.
It got me thinking -- isn't this what I should have been doing all along? Here's my thinking: my portfolio should have both long and short positions (for simplicity let's say long and short ETFs). When the market goes up, I sell the long ETFs to take out the profits and when the market goes down I sell the short ETFs to take out the profits. Anything wrong with this idea?
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The stock market is a lot like a roulette table. Your strategy doesn't take advantage of any of the differences between the stock market and roulette, so if it'll work in the stock market, it will work in roulette. Conversely, of course, if it doesn't work in roulette, it won't work in the stock market, either.
So, imagine that you're standing at a roulette table. The wheel has 37 numbers, of which 19 are black and 18 are red.
Your strategy is to bet on black and red at the same time. No matter what number comes up, you'll win . At that point, you just take your off the table (the original bet plus the profit) and go home with your winnings.
Do you see the problem with this strategy?
The problem is that you never actually make any profits.
It makes sense to have long individual stock positions and short market ETF at the same time if such strategy has higher return than buy and holding the individual stock positions on a risk adjusted basis.
It does not make sense to have long market ETF and short market ETF that are extremely negatively correlated, e.g. long S&P 500 ETF and short US Total Market ETF, because doing that would be akin to buying both Red and Black on a Roulette table in a casino and you lose the 0 and 00 (brokerage comission, bid/ask spread, short borrowing fee).
If the long and the short positions are highly correlated and very similar (eg SPY and VOO), the net result will be in the vicinity of zero, regardless of what the market does. What one leg makes, the other leg loses.
What you are suggesting requires perfect timing, closing the winning position with the expectation that the losing position recovers, offering the possibility of recovering your paper losses. If the losing leg doesn't reverse then you have booked a gain while accruing an equivalent paper loss and now you are going to accrue additional losses on the losing side.
There are situations where a short position makes sense. For example, like yesterday when the market was tanking (DJIA down 1,800) and you want to either hedge your existing portfolio short term (intraday or for a few days) or if you are just trading the momentum of price (no portfolio).
Another possibility is pairs trading in correlated issues. This market independent and you are trading the spread between the two securities, in the expectation that the spread between the two will contract. For a simple example, two gold stocks where XYZ has run up quickly and you expect (hope for?) a reversal. Buy ABC and short XYZ. The pair profits if ABC catches up or XYZ retraces, narrowing the spread. If achieved, close both positions. A variation of this is if the pair makes a decent move up or down, replace the winning leg with an appropriate over (or under) valued third gold stock that hasn't made a similar move. This type of trading is more viable in volatile periods (like March) when the components percolate much more intraday and daily.
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