First, I recommend the use of put options in lieu of borrowed shares. This would make impossible the dreaded margin call–which occurs when an investor’s securities reach about 75% of his credit balance. The obvious drawback of using put options is that the premium paid may neutralize any perceived spread.

My second solution is to simply close out short positions at a loss if the long position continues to get relatively cheaper. This so called “risk management” seems irrational, since the expected value has actually improved. However it would have prevented failure in a great majority of instances, precisely because other similarly situated people had done it. When Salomon Brothers closed out its Royal Dutch/Shell trade (i.e. covered the RDA short and sold SHEL) in the summer of 1998, the safest action was to do the irrational thing and close the position.

Of course it would be best to avoid long-short positions entirely. I believe that the ideal situation would involve some sort of event-driven hedge requiring two long positions. This may require a lot of patience as any opportunity would be scarce by its terms.

Take to heart, though, what David Einhorn wrote in his recent book. He mentioned that although relative value can seem attractive, you often end up buying ’6′s’ and shorting ”5′s’ instead of buying ’10′s’ and shorting ’1′s’ (1 being a great short, 10 a great long). Instead, if you’re always looking for 10′s to buy and 1′s to short, you are shooting at better returns.

I’d say, personally, that if you are going to be engaged in relative value arb., make very very sure that the companies face the same risk factors. If you assume they do, but there is one risk that hits your long or your short, but not equally to both, one might go way off in the wrong direction, and you’re left with a couple of mediocre investments.

Overall, it will probably do fine if you find great opportunities. It has always struck me that the strategy can end up being one, if you’re not very careful, of “I got it, I got it, I don’t got it!” when the spread blows out on you because some risk hit that you didn’t properly consider. I suppose this is a risk with all investments, but those considering relative value arb. should be especially atuned.

You probably already know this well, but I felt it needed to be brought up.