In a long (buy) position, the investor is hoping for the price to rise. An investor in a long position will profit from a rise in price. The typical stock purchase is a long stock asset purchase.
A long call position is one where an investor purchases a call option. Thus, a long call also benefits from a rise in the underlying asset’s price.
A long put position involves the purchase of a put option. The logic behind the “long” aspect of the put follows the same logic of the long call. A put option rises in value when the underlying asset drops in value. A long put rises in value with a drop in the underlying asset.
In a long asset purchase, the potential downside/loss is the purchase price. The upside is unlimited.
In long calls and puts, the potential downsides are more complicated. These are explored further in our options case study.
A short position is the exact opposite of a long position. The investor hopes for, and benefits from, a drop in the price of the security. Executing or entering a short position is a bit more complicated than purchasing the asset.
In the case of a short stock position, the investor hopes to profit from a drop in the stock price. This is done by borrowing X number of shares of the company from a stockbroker and then selling the stock at the current market price. The investor then has an open position for X number of shares with the broker, that has to be closed in the future. If the price drops, the investor can purchase X amount of stock shares for less than the total price they sold the same number of shares for earlier. The excess cash is their profit.
The concept of short selling is often difficult for many investors to grasp, but it’s actually a relatively simple process. Let’s look at an example that will hopefully help clarify things for you. Assume that stock “A” is currently $50 per share. For one reason or another, you expect the stock price to decline so you decide to sell short to profit from the anticipated fall in price. Your short sale would work as follows:
- You put up a margin deposit as collateral for your brokerage firm to loan you 100 shares of the stock, which they already own.
- When you receive the 100 shares loaned to you by your broker, you sell them at the current market price of $50 per share. Now you no longer have any shares of the stock, but you do have the $5,000 in your account that you received from the buyer of your 100 shares ($50 x 100 = $5,000). You are said to be “short” the stock because you owe your broker 100 shares. (Think of it as if you said to someone, “I’m 100 shares short of what I need to pay back my broker.”)
- Now assume that, as you anticipated, the stock’s price begins to fall. A few weeks later, the price of the stock has dropped all the way down to $30 a share. You don’t expect it to go much lower than that so you decide to close out your short sale.
- You now buy 100 shares of the stock for $3,000 ($30 x 100 = $3,000). You give those 100 shares of stock to your broker to pay him back for (replace) the 100 shares he loaned you. Having paid back the 100 share loan, you are no longer “short” the stock.
- You have made a $2,000 profit on your short sell trade. You received $5,000 when you sold the 100 shares your broker loaned you, but you were later able to buy 100 shares to pay him back for only $3,000. Thus, your profit is figured as follows: $5,000 (received) – $3,000 (paid) = $2,000 (profit).
Short stock positions are typically only given to accredited investors, as it requires a great deal of trust between the investor and broker to lend shares to execute the short sale. In fact, even if the short is executed, the investor is usually required to place a margin deposit or collateral with the broker in exchange for the loaned shares.
Short call positions are entered into when the investor sells, or “writes”, a call option. A short call position is the counter-party to a long call. The writer will profit from the short call position if the value of the call drops or the value of the underlying drops.
Short put positions are entered into when the investor writes a put option. The writer will profit from the position if the value of the put drops or when the value of the underlying exceeds the strike price of the option.
Short positions for other assets can be executed through a derivative known as swaps. A credit default swap, for example, is a contract where the issuer will pay out a sum to the buyer if an underlying asset fails or defaults.
There is a wide variety of long and short positions that traders may adopt. A knowledgeable investor will have grasped the many advantages and disadvantages of each individual type of long and short positions before attempting to incorporate using them into his or her trading strategy.