Explaining a Long and Short Position when Investing
There are two main positions related to the fluctuations of a security: a short and a long position. Some investors benefit if the market goes up, while others will benefit 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 whom operate with the belief that the market will go up, while the bear pictures "bearish" investors, whom orient their actions on the expectation the market will go down. Let's go through the characteristics of both positions.
The long position is the natural investors' position adopted by most investors, and comes from owning securities. When an investor buys a share, he expects it to gain value in order to eventually resell it at a higher price, or to cash dividends. The main idea of the long position is that the investor benefits from holding on to the purchased shares for a period of time, and he succeeds if the owned securities appreciate.
This long position also exists with derivatives. For example, when a trader purchases a call option, he hopes the value of the underlying shares will go up. A call is a purchase option that gives the right to the holder (but not the obligation) to buy defined financial products at a specific price and before a certain time. If the underlying shares increase in value at the time the holder fulfills his option agreement, then the predefined purchase price of the shares will be lower than market value, and therefore it will be profitable for the investor.
A similar position can be observed when an investor sells a put option. A put follows the same logic as a call, but for selling purposes. The put is the right (but not the obligation) to sell defined financial products at a specific price and 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 will be higher than its market value. If the option agreement is not fulfilled, the investor that sold the option wins by selling an unused put.
The short position is somewhat unnatural, but very present in the financial market. This position takes its origin from short selling, where a speculator sells securities without owning them. The principle of short selling entails borrowing a security to cash its sale immediately, only to buy it back later, preferably at a lower price. Basically, a broker borrows shares and then sells them at market price for the speculator. This is what we call a short position, where the speculator hopes to profit from the shares' devaluation; he sells the security at a higher price just before it devaluates, and then buys it later at a lower price.
Taking the same example of short selling, but with options, an investor is in a short position when he buys a right to sell (put). The investor speculates that the price of the underlying securities will go down, and then profits from selling them at the predefined option price, which would be higher than market value. Similarly, when selling a right to buy (call); the option owner won't buy the shares at the predefined option price if the shares devaluated, because the market price would then be lower than the option price.
Buying Shares vs. Short Selling
An investor will profit from stock fluctuations whether he is in a long or short position. Purchasing and short selling stocks (or any other securities) are two opposite and exclusive actions. An investor will benefit from a share increasing in value, but if it decreases, the short seller will benefit. Mathematically, the gain of one would be the loss of the other, and vice versa.
As an example, let's take a scenario where a share is worth $10.00 market value, and which increases to $15.00, excluding the transaction cost. The investor that purchased the share at $10.00 could make a gain of $5.00, while the one short selling it (who is cashing the sale at $10.00 and later buying it back at $15.00) will lose $5.00. If instead, the share devaluates to $3.00, the one that bought it would be losing $7.00, and the one who short sold it would make a profit of $7.00.
Moreover, unlike holding stocks, short selling cannot be indefinite. When short selling, the one who cashed the sale of the borrowed stocks is obliged to buy the stocks back at market value, and at a predefined time. In contrast, if the investor owns the shares/stocks, he is never forced to sell.
The worst-case scenario when owning a share is seeing its value drop to zero. In this case, the loss would be limited to its purchase price. When short selling, the worst-case scenario would be that the share value increases indefinitely, potentially leading the investor to an infinite loss.
When it comes to gains, the maximum profit when short selling is the shares purchase price. In contrast, if you own the share, the profit could be unlimited. Short selling is then riskier than owning stocks because the loss can be infinite and the gains are limited to the shares value.
When to Short Sell?
An investor's actions are based on whether he believes the market will go up or down. The long position is the one most used by investors, while the short position is reserved to more experienced players. As a matter of fact, short sellers are often blamed during times of crisis due to their influence and pressure for the market to go down. Bottom line, an investor's move has to be well calculated or infinite losses could become a reality. He should monitor closely his portfolio, or give the mandate to more experienced investors.