When speaking of stocks and options, analysts and market makers often refer to an investor having long or short positions.
Just by looking at the names long and short it may seem like they have to do with length of some sort however this is not the case.
To put it simply, taking a long position is when you buy securities or other financial instruments in hopes of the price going up. When the share price goes up you make money and when it goes down you lose money.
In a long position you also have ownership in the stock meaning that you own a portion of the company you are investing in.
For instance, if you bought 100 shares in Microsoft, you are long 100 shares. You have paid the full cost of owning the shares.
Sounds simple enough but you may be thinking, “Isn’t that how investing works? Why would you want the price to go down? Don’t you always own your shares when you buy them?”
Stick with me and we’ll go through all of this and more.
On the flip side, there is short trading often called shorting a stock, going short, taking a short position or selling short.
When you go short, instead of making money when the share price goes up, you make money when it goes down.
But if you buy shares and then sell them at a lower price how do you make money?
Here’s the thing, you don’t actually buy any shares when you go short. You are borrowing them from someone else and then selling them right away.
When the price goes down, you can then buy back the shares and give them to the person you borrowed them from (typically the broker).
Think about it like this. If your friend lent you his brand new 2020 car he paid $20,000 for and you sold it right away for that same amount you’d have $20,000 in your bank account. But your friend still wants his car back.
Say you wait a month for the 2021 model of that car to come out so that the 2020 model drops by $5,000.
When this happens, you buy a new 2020 car to give to your friend and you keep the difference, which in this case is $5,000.
You make $5,000 and your friend gets the car back, everyones happy.
Of course with cars there are other factors such as depreciation but for this example just assume there aren’t any.
The same concept applies to short trading, just with stocks instead of a car and the broker is your friend.
Since you are borrowing the shares, you need to have a margin account in order to make the transaction.
As with everything, short trading comes with its own set of risks.
Unlike with going long where you can only lose however much money you invested, when you go short your losses can theoretically be infinite.
This is because when you go long, the stock price can go as low as zero dollars and that’s it. You lose money when it does down and that’s the lowest it can go.
When you go short however, you lose money when the share price goes up and theoretically the price can go up forever.
A stock that’s $1 could go to $100 and in that scenario you lose 100x your investment.
If you’ve been keeping up with the news you’ve probably heard about how hedge funds are losing tons of money by short selling the company GameStop because the price keeps on rising.
This just shows that no one is safe from the risks of going short. Not even the big guys.
As I recommend with all trading, you should set stop losses so that your maximum loss is calculated before you even make the trade.
This way you know how much you are risking and don’t panic if the stock price were to go up.
When you go short you are also responsible for paying the interest on the borrowed shares as well as any dividend payments (the broker wants those too since they’re missing out on them by lending you their shares).
Is It Ethical?
Short selling is often criticized as being unethical because when companies performance in the market declines, often this leads to real people losing their livelihoods.
Short selling puts downward pressure on stock prices which may drive the price down.
The reality, however, is quite different. Far from being cynics who try to impede people from achieving financial success, short sellers enable the markets to function smoothly by providing liquidity and also serve as a restraining influence on investors’ over-exuberance.
There is a need for balance in the markets and short selling provides this.
The Bottom Line
Short trading is an advanced method that should be used by more sophisticated investors. It comes with more risks than the average long trade and there is unlimited liability.
As with other advanced trading methods, be careful if you do try short trading and make sure that you have the proper precautions in place so that you aren’t in for any unnecessary surprises.
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