by Martin Chapman

Created on: July 05, 2008   Last Updated: March 28, 2009

Stocks prices rise and fall all the time. How can we make money, irrespective of which way the market moves? Ideally this means having the stocks while they are rising and having a methodology to deal with the stocks when they are falling. This article concentrates on two types of investor: The Long Only Investor and The Short Investor.

THE LONG ONLY INVESTOR

The long only investor is simpler to understand. He holds stocks that he owns and he selects the stocks that will give him the best absolute return. Whether he trades in and out of the market or stays for a longer term in the market, he knows that he has one biased factor in his favor and that is that shares, as an asset class, can perform very well over the long-term. For example Jones and Wilson, calculated that real stock returns on the S&P500 averaged approximately 7% for the period 1926-2004 (The Financial Review: 2006)

The long investor wants to be in for the upswings, but wants to be well away during the downswings. The long investor likes falling shares, especially if: a) he does not have them; and b) they are exactly the shares he has his eye on to buy. Fundamental and Technical analysis will tell him if the stock is highly or lowly priced. The all important factor will be the timing of his execution.

The long only investor can choose to leave the market for certain phases in the year. For example, academic studies do prove that the simple "SELL IN MAY AND GO AWAY" strategy can greatly increase the returns of a Long Only Investor. Why do shares drop during these months? This is because the full year results have already been published; share prices have already peaked on that news; liquidity is low as traders are on vacation; and analysts shave earnings so firms can beat expectations later.

Where it is clear to the Long Only Investor that the markets are falling, e.g. in a Bear Market, then he may choose to hedge his portfolio. There are a number of ways of doing this, such as buying a Put Option or selling a Future Contract on specific stocks or indices. The degree to which you have insulated or insured your portfolio is measured by the "delta". This comes from the Greek word for change. Therefore a delta =1 means that your hedge is a perfect match.

Unfortunately there are problems with the perfect hedging of portfolios. For example in Europe you may have a Dow Jones Stoxx50 index portfolio and want to hedge it, but you find that the Stoxx50 future is totally illiquid. You are forced therefore

• 1
• 2
• 3
• Next Page >>