Is a Long/Short Approach Worth Taking?

For investors who are a not familiar with the terms, going long on a stock is buying stock and holding it in the hopes that it will increase in value. Going short means selling a stock that is not owned, which creates a negative position. Eventually, the negative position (short position) needs to be covered, meaning shares will be bought back in order to bring the position back to even.

As most are aware, when a stock is bought, the owner receives the dividends paid as a source of income. When shares are shorted, however, the investor is required to pay out the amount of the dividend to the person the shares were borrowed from. If the stock does not decline in value, a short seller will not make any profit.

Many years ago, when the first hedge funds began, the idea used to minimize risk was to employ a long/short strategy, which meant that for every share that was bought in a specific industry, another share in the same industry had to be shorted. The approach to risk minimization or investing shifted the responsibility away from picking the winner to simply picking the race horse that would cross the finish line before another race horse. Investors are only required to pick two race horses out of the group — any two!

A good example of this strategy in today’s market would be to purchase shares in a company such as BCE Inc. (TSX:BCE)(NYSE:BCE) and then to short the shares of Telus Corporation (TSX:T)(NYSE:TU).

Shares of BCE currently trade at a trailing price-to-earnings (P/E) ratio of less than 18 times and pay a dividend of close to 5%. When an investor purchases these shares at a price of $58 per share, the investors will receive the upside when shares rise and when dividends are paid.

In the case of Telus, the investor will short shares at a price of $45 and be responsible for paying the dividend, which is currently yielding slightly more than 4.25%. Currently, shares of Telus trade at a trailing P/E of 21 times.

Given the strategy, the investor is not actually out of pocket for the amount of the dividend. Instead, the inflow from the dividends paid by BCE will be enough to cover the amount of dividends owed on shares of Telus. Regarding the profit or loss from the increase or decrease in share prices, there are a number of ways for the investors to make money.

Beginning with the increase in share price of BCE, the shareholder will make money if shares of Telus do not move (which would have offset the gain). If shares of Telus decline in value, or even increase in value, it is still possible to make a profit; it’s conditional that shares do not increase by more than the shares of BCE. The long/short strategy constantly has one position offsetting the other.

Investors employing this strategy have the opportunity to make money in more ways than one. The downside, however, is that one profitable trade can be more than offset when picking the wrong horse. As always, it is best to invest diligently.

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Fool contributor Ryan Goldsman has no position in any stocks mentioned.

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