Long and Short Position in the Investment World
There are two main positions related to the fluctuations of a security: the short and long position. Some investors will benefit if the market goes up, and others will if it goes down. This is demonstrated by the symbol of the bull and the bear, both describing a market trend. The bull pictures the optimistic "bullish" investors operating with the belief that the market will go up, while the bear show "bearish" investors orienting their actions on the expectation it will go down. Let's go through the characteristics of both positions.
The long position is the natural investors' position, which comes from owning securities. When an investor buys a share, he expects it to gain value and eventually have the option to resell it at a higher price, or cash some dividends; the idea of the long position is to benefit from holding on the shares you purchased. The investor wins if the owned securities appreciate.
This position also exists with derivatives. For example, when an trader purchases a call, he hopes the value of the underlying products will go up. A call is an option that gives the right to the holder, but not the obligation, to buy defined financial products at a pre-specified price, before a certain time. If it is the case and the underlying securities increase in value at the time the holder can fulfill his option agreement, the predefined purchase price will be lower than the market value, and therefore it is open for profit.
A similar position can be observed when someone sells a put. A put follows the same logic as the call, but for selling purposes. The put is the right, but not the obligation, to sell defined products at a specific price before a certain time. The one who sells the put hopes the value of the underlying asset will increase, because if it actually decreases, then he will have to buy the product at the predefined price, which is higher than the market. If the option agreement is not fulfilled, the one that sold the option wins by selling an unused put.
The short position is a bit unnatural, but very present in the financial market. This position takes its origin from short selling, where a speculator sells securities without owning it. The principle of short selling is to borrow a security and cash its sale immediately, only to buy it back later, preferably at a lower price. In a more practical term, it is the broker that borrows the shares to another one, and then sells them at the market price for the speculator. This is a short position, because the speculator hopes to profit from the shares' devaluation; he would have sold them at a higher price just before it devaluates, and then buy them later at a lower price.
Taking the same example with the options, the investor is in a short position when he buys a right to sale (put). He speculates in that case that the price of the underlying securities will go down, and then benefits from selling them at the predefined option price, which would be higher than the market. Same thing when selling a right to buy (call); the option owner won't execute its contract if the shares devaluate and the market price would be lower than the option price. This again would profit the person selling an unused option.
Buying vs. short selling shares
The stock fluctuations will profit an investor whether he is in a long position or short position. Purchasing and short selling stocks, or any other securities, are two opposite and exclusive actions. A share increasing in value will benefit the owner, and if it decreases, the short seller. Mathematically, the gain of one would be the loss of the other, and vice versa.
Let's take a scenario where a share is worth $10.00 on the market and increases to $15.00, excluding the transaction cost. The one that purchased it at $10.00 could make a gain of $5.00, while the one short selling it, which is cashing the sale at $10.00 and thereafter buying it back at $15.00, will lose $5.00. If instead the share devaluates to $3.00, the one that bought it could cover a loss of $7.00, and the one who short sold it would make a profit of $7.00.
Moreover, short selling cannot be indefinite like holding stocks. Eventually, the one who cashed the sale of borrowed stocks would need to buy it back at the market price when the time comes, as opposed to owning them, which never forces you to sell.
Also, the limits of potential gain and loss for the two actions differ. The worst case scenario when owning a share is seeing its value dropping to zero, so the loss is limited to its purchase price. For short selling, the worst case scenario is that the share value increases indefinitely, which in theory exposes the speculator to an infinite loss. When it comes to gains, the maximum profit of short selling is limited to the share's purchase price, but there is no limit in making profit if you decide to hold on to it. Short selling is then a riskier proposition than owning stocks, because the loss can be infinite and gain limited to the share's value, but the potential gain is very real.
When should we short sell?
The investor's actions are based on their vision of a market that will go up or down. The long position is the one aimed by most investors, and the short position is reserved for more experienced and sophisticated players. Actually, short selling is often finger pointed in time of crises, due to putting devaluating pressure on the market. Bottom line, if the move is not well calculated, taking the chance to have an infinite loss should be left to advanced investors who can monitor closely their portfolio.