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Hedge Fund · Topic lesson

Long / Short Equity

How a long/short book is measured, hedged, financed and sized: gross and net exposure, beta-neutral pairs, the cost of shorting, risk budgets, crowding and factor overlap.

5 chapters About 52 minutes0 of 5 complete
Start chapter 1

A long/short equity fund buys stocks it expects to beat the market and shorts stocks it expects to lag, so it can make money from its picks whichever way the market goes. Interviewers test whether you can put numbers on that: how much market the book really owns, how a hedge is sized, what a short costs to hold, and how big each idea is allowed to be. This lesson follows a position through the book.

How a short works. You borrow shares through a prime broker, sell them, and buy them back later to return them, profiting if the price falls. The most a short can make is 100%, if the stock goes to zero; the loss has no ceiling, which is one reason shorts are sized carefully.

  • Measure the book. Gross exposure is how much is at work; net exposure is which way it leans; beta says which way it really leans.
  • Hedge the idea. A pair trade sized by beta removes the market and leaves the view.
  • Pay for the short. Borrow fees and dividends, against the interest on the proceeds.
  • Size it. A risk budget and a stop-loss rule, not conviction.
  • Plan the exit. Days to exit, crowding, and how much of the stock is really a factor.
The rule that solves every question

Count market exposure in beta-dollars, not dollars. A dollar of a beta-1.5 stock carries $1.50 of market. Hedge sizes, net exposure and market P&L all come out right once each side is weighted by its beta. Hedging the market with index futures is covered in Portfolio Risk.

A position, from idea to exit

Each step points to the chapter that practices it.

  1. 1
    Measure the book

    Gross, net and beta-adjusted net.

    Chapter 1
  2. 2
    Hedge the view

    Size the short by beta-dollars.

    Chapter 2
  3. 3
    Pay to hold the short

    Rebate, less borrow fee and dividend.

    Chapter 3
  4. 4
    Size the idea

    A risk budget and a stop; the smaller wins.

    Chapter 4
  5. 5
    Plan the exit

    Days to exit, crowding and factor overlap.

    Chapter 5

Chapters

1

Gross and net exposure

10 min

Two numbers describe a long/short book: how much is at work, and which way it leans. Beta tells you which way it really leans.

  • Calculate gross, net and beta-adjusted net exposure
  • Predict the P&L of a market move from beta-adjusted net
  • Find the short book that brings net exposure to a target
  • Say what gross exposure measures that net does not
2

Beta-hedged pair trades

12 min

Long one stock, short another, and size the short so the market washes out. What is left is the view.

  • Size a short so a pair is beta-neutral
  • Split a pair's P&L into market and stock selection
  • Back out a stock's alpha from the P&L
  • Show what a dollar-neutral pair leaves behind
3

The cost of carrying a short

9 min

Short proceeds earn interest, but the borrow fee and the dividend come out of it. The net is the hurdle a short must clear.

  • Calculate the rebate, the net carry rate and the carry over a holding period
  • Work out how far a stock must fall to pay for a negative carry
  • Find the highest borrow fee before the carry turns negative
  • Show what a hard-to-borrow name costs
4

Sizing a position to a risk budget

11 min

Size is not conviction. Each idea gets a slice of risk, and a stop-loss rule sits beside it. The smaller answer wins.

  • Size a position to a contribution-to-risk budget
  • Size it to a stop-loss limit, and say which rule binds
  • Back out the correlation a risk system is assuming
  • Resize a position after a jump in volatility
5

Crowding and factor overlap

10 min

Two risks the volatility number hides: how long it takes to get out, and how much of the stock is really a factor bet.

  • Calculate days to exit from trading volume and participation
  • Find the largest position a days-to-exit limit allows
  • Split a stock's variance into factor and idiosyncratic parts
  • Say why crowded positions fall together