Stock Trading: Long Position vs Short Positions
Stock Trading: Long Position vs Short Positions
Long? Or short? It all depends on what you think the market will do!
As you’re learning, stock trading has its language. And if you’re just starting with stock and forex trading, it is easy to get confused by all the terms. However, it is nothing to worry about; even the best traders were once in your shoes.
Long? Short? You may find yourself equating them with buy and sell often. But they’re not precisely buying and selling as you think.
So, what exactly is a long position? When are you in a short position? When should you go long or short?
In this piece, you’ll get to understand the detailed meaning of long and short positions and when to use them.
What is a Long Position?
The term long position indicates what you purchased when you buy an asset (security or derivative) when you expect that asset to increase in value. That is, you expect it to be bullish at the end of your trading period.
When you are long, that means you’re the holder of the assets. Therefore, you initiate a long trade when you buy with the expectation to sell in the future for a higher price and take profit.
Day traders often use long and buy interchangeably. So, you may hear an investor say buy instead of long. Some trading software have their entry position marked as “long,” while others have it marked as “buy.”
So, if you hear a trader say I’m long Gold or I’m going to long Gold.” What they simply mean is that they want to open a long position on Gold. They are on long positions because they expect the gold price movement to be bullish (price rising).
However, sometimes the long position is also used in the context of option buying. When that is the case, there are 2 types of long positions you can hold:
Long call
Long put
Long Call
The long call is when you buy the right (option) to buy the underlying asset at a specified price. You go long on a call option when you’re sure the price movement is bullish.
You can buy at the specified price when the price moves above your strike price with your long call option. You then resell at the current price and take profit.
Long Put
On the other hand, when you go long on a put option, you’re buying the right to sell at a specified price. So, in this instance, you’re speculating that the price movement will be bearish.
With your long put option, you hope to be able to sell the underlying asset at an advantageous price during the expiration of your trade.
What is a Short Position?
A short position or short is when you first sell an asset to repurchase it at a lower price.
You enter a short position when you believe that the price movement will be bearish in the future. That is, you expect that the price of the security or assets is likely to go down. So, you enter into a short position to profit from that.
Most times, traders/investors borrow the shares of that security from their broker or a stock loan department.
There are two types of stock position you can place:
Naked short
Covered short position
Naked Short
A naked short position is when investors sell security they don’t have yet. Naked short positions are illegal, and they are banned in the U.S. for equities.
Covered Short
A covered short position is when you borrow shares from a stock loan department or your broker to sell. In return, you’ll have to pay a borrowing rate for the period the trade is in place.
The Differences between Long and Short Positions
Entry
When you enter a long position, that means that you already bought and own shares of that stock. On the other hand, when you enter a short position, you owe stock to another and must repay at the end of your trade.
However, it is slightly different in options trading. When you buy or hold a call or put option, you’re in a long position. And you’re in a short position when you’re selling or writing a call or put option.
Price Action
When you long an asset in stock trading, you’re speculating that price action will rise (i.e., you’re bullish. Except for options trading (long put), Long position traders are bullish.
On the contrary, when you short a stock, you’re expecting that the market price will fall (i.e., you’re bearish).
Exit
You exit a long position when you sell your shares and close the trade. In contrast, you close a short position by buying the shares to repay/replace your debt to the stockbroker. You want to buy lower, return your debt, and take profit.
Profit/Loss
In a long position, your profit is unlimited as long as the price keeps rising. And you lose when your asset is below your purchase price. Therefore, for a long position, you’ve unlimited profit potential and limited loss potential.
However, your loss potential becomes unlimited if the price reverses and keeps rising when you go short. But, on the other hand, your profit is limited to the stock’s distance to zero. So, you have got an unlimited loss potential and a limited profit potential.
Understanding how Long Positions and Short Positions Work
Knowing in detail how long and short positions work is key to understanding how to trade them well. When should you go long, how do you calculate your profit? When should you take profit?
How Do Long Positions work?
In a long position, you want to buy low and sell high. When you open a long position, it means that you’ve bought, and now, you owe shares of that stock. You’re speculating that there will be an increase in the price. The typical stock share purchase is a long trade, i.e., you want to sell at a higher price.
Your profit is [(current market price – initial price) x 100]. For example, let’s say you buy 100 shares of Stock A at $50 each, which is $5000. Suppose the price increases to $100, you’d be in profit of $5000 [($100 - $50) x 100].
On the other hand, if the price falls below $50 to say $30, you lose $2000 [($50 - $30) x 100]. So, you’ll get back $3000 on the shares you bought for $5000 in case you close the trade.
Leverage trading is when you borrow more money from your broker to get more from your trade. So, instead of paying the total initial value of $5000 alone. You can pay $500 on leverage of 10x.
However, it is very risky for leverage trading in an unstable market. A slight shift in price movement can cause liquidation.
How Do Short Positions work?
When you’re in a short position, you want to sell high and buy low. That is, before you open a short position, you’re speculating a drop in the market price.
So, you borrow a certain number of shares from your stockbroker and wait for a decrease in the market price. Then, you’ll have to put up a margin deposit as collateral for your brokerage firm.
At that point, you have an open short trade for the number of shares you borrowed. That means you owe your broker that number of shares that you must repay to close the trade.
If the price drops, you purchase the stock back at a lower cost to pay your debt. Thus, your profit is the [(the initial price – the current market price) x the number of shares].
For example, let’s assume the current price of stock A is $100 per ton. But you’re speculating a future drop to $50, so you decide to sell short to profit from the run. So, you put up the margin deposit and proceed to get 100 shares at $100.
When you receive the 100 shares, you sell immediately at the current price. So, you don’t have the shares any longer, but you have $10,000 ($100 x 100) in your account from selling the shares. And you still owe your broker 100 shares.
If the market price drops to $50 as expected, you repurchase the 100 shares at $50. That is, you pay $5000 ($50 x 100) to repay your broker. You can then close the position by paying back your debt (100 shares). In the end, your profit is $5000 [($100 - $50) x 100] minus the broker’s fee.
However, if the price movement didn’t go according to your plan and the market price increases to $120 instead. You have to buy each share at $120 to repay your loan/debt. So, you’re in a loss of $2000 [($120 - $100) x 100].
If the price keeps increasing and your short position is still open, the trader may get a margin call from the broker.
Margin Call
A margin call occurs when the trader’s account value goes below the broker’s required minimum to keep the position open. The margin call is usually for the trader to deposit more money or securities to keep the trade open. Failure to do that leads to liquidation.
Short Squeeze
A short-squeeze is when a heavily shorted asset suddenly becomes bullish, i.e., a sudden stock price jump. That forces the short traders to quickly close their position to avoid more losses, which pushes the price higher.
Conclusion
You can use long and short positions to achieve different results. Sometimes, an investor may create both long and short positions simultaneously to leverage their risk.
Whether you open a long or short position depends on your analysis of the price movement. For example, if bullish, long, and if bearish, short!
When in long and short positions, especially short positions, ensure that you follow proper risk management. Suppose there is a price reversal, and the market is moving in the opposite direction. In that case, it is okay to close your trades to avoid further losses.
Keep in mind that trading long and short positions are more complicated in derivative (Future and option) trading. So, you should wait until you have more experience before derivative trading.
