The biggest risk involved with a short position? Losses are theoretically unlimited. However, this risk can be effectively controlled through the use of risk mitigation techniques such as stop losses and portfolio diversification.
Despite the goal of market neutrality, some relative value trades become more risky as market volatility rises. This is because volatile markets tend to exacerbate mispricing of assets. Therefore, it's imperative that one carefully choose entry and exit points and have a predefined strategy for managing risk.
Beta, a measure of an asset's historical volatility relative to the market, can be used to manage risk so that one side of the trade does not move too radically in relation to the other. That said, since beta is a historical measure, there's no guarantee it provides an accurate forecast of the future. Finally, if a trade is successful, the dollar amounts of either side of a trade will diverge, making it necessary to periodically rebalance the trade.
Last but not least, a portfolio containing relative value trades will have less overall risk if the theses behind those ideas are unrelated, and therefore, less correlated. In writing this article we thought our readers would be interested in ideas related to the unfolding of the coronavirus crisis. That said, in creating portfolios for clients, we strive to identify relative value ideas with different underlying drivers.