What is the 130-30 Strategy
The 130-30 strategy is a strategy that uses financial leverage by shorting poor performing stocks and purchasing alternate shares that are expected to have high returns. A 130-30 ratio implies shorting stocks up to 30% of the portfolio value and then using the funds to take a long position in the stocks the investor feels will outperform the market. Often, investors will mimic an index such as the S&P 500 when choosing stocks for this strategy.
BREAKING DOWN 130-30 Strategy
To engage in a 130-30 strategy, an investment manager might rank the stocks used in the S&P 500 from best to worse on expected return, as signaled by past performance. A manager could use direct S&P data or data from additional sources, such as the Wall Street Journal’s MarketWatch, Bloomberg, and more. From these best ranking stocks, the manager would invest 100% of the portfolio's value and short sell the bottom ranking stocks, up to 30% of the portfolio's value. The cash earned from the short sales would be reinvested into top-ranking stocks, allowing for greater diversification in the higher ranks.
130-30 Strategy and Shorting Stocks
The 130-30 strategy incorporates short sales as a significant part of its activity. Shorting a stock entails borrowing securities from another party, most often a broker, and agreeing to pay an interest rate as a fee. A negative position is subsequently recorded in the investor’s account. The investor then sells the newly acquired securities on the open market at the current price and receives the cash for the trade. The investor waits for the securities to depreciate, and then re-purchases them at a lower price. At this point, the investor returns the purchased securities to the broker. In a reverse activity from first buying and then selling securities, shorting still allows the investor to profit.
Short selling is much riskier than investing in long positions in securities; thus, in a 130-30 investment strategy, a manager will put more emphasis on long positions than short positions. Short-selling puts an investor into a position of unlimited risk and a capped reward. For example, if an investor shorts a stock trading at $30, the most she can gain is $30 (minus fees), while the most she can lose is infinite since the stock can technically increase in price forever.
Other forms of investing and trading strategies include arbitrage strategies, in which investors attempt to gain from price discrepancies in similar securities.