Long and short positions

LINK_POOL:

• internal:
  • anchor_text: Options
    slug: options
  • anchor_text: Futures Contracts
    slug: futures-contracts
  • anchor_text: Margin Account
    slug: margin-account
  • anchor_text: Bear Market
    slug: bear-market
  • anchor_text: Bull Market
    slug: bull-market
  • anchor_text: Market Sentiment
    slug: market-sentiment
  • anchor_text: Volatility
    slug: volatility
  • anchor_text: Arbitrage
    slug: arbitrage
  • anchor_text: Risk Management
    slug: risk-management
  • anchor_text: Hedging
    slug: hedging
  • anchor_text: Securities and Exchange Commission
    slug: securities-and-exchange-commission
  • anchor_text: Exchange-Traded Funds
    slug: exchange-traded-funds
  • anchor_text: Dividends
    slug: dividends
  • anchor_text: Call Options
    slug: call-options
  • anchor_text: Put Options
    slug: put-options
• external:
  • anchor_text: Securities Exchange Act of 1934
    url: https://www.sec.gov/rules/other/34-50103.pdf
  • anchor_text: Regulation SHO
    url: https://www.sec.gov/files/regsho.pdf
  • anchor_text: Short Selling Risk
    url: https://rady.ucsd.edu/faculty/directory/engelberg/pub/Short_Selling_Risk.pdf
  • anchor_text: Isaac Le Maire
    url: https://www.quantifiedstrategies.com/history-of-short-selling/

What Are Long and Short Positions?

In finance, long and short positions represent two fundamental stances an investor can take on an asset's price direction. Taking a long position, often simply referred to as being "long," means an investor buys an asset with the expectation that its price will increase over time. This is the more traditional form of investment, where the investor profits from an upward price movement. Conversely, taking a short position, or "shorting," involves selling an asset that the investor does not own, with the expectation that its price will fall. The investor aims to buy back the asset at a lower price in the future, returning it to the lender and profiting from the difference. These concepts are central to Investment Strategies and Market Operations, forming the basis for many trading and hedging activities within the broader category of Capital Markets.

History and Origin

The practice of short selling, which is the basis for a short position, has a long and often contentious history, with its origins tracing back to the early 17th century. The concept is widely attributed to Isaac Le Maire, a Dutch merchant who, in 1609, reportedly sold shares of the Dutch East India Company that he did not own, anticipating a decline in their value.¹⁴, ¹⁵ This early form of shorting was driven partly by personal grievances and a belief that the company's shares were overvalued.¹³

Over centuries, short selling evolved, but it frequently drew criticism, particularly during periods of market instability. For instance, short sellers were blamed for exacerbating the Wall Street crash of 1929.¹² This led to increased scrutiny and, eventually, regulation. In the United States, the Securities Exchange Act of 1934 granted the Securities and Exchange Commission (SEC) the authority to regulate short sales.¹¹ The SEC's first significant restriction, known as the uptick rule, was adopted in 1938, stipulating that a short sale could only be made at a price higher than the previous trade, aiming to prevent short sales from accelerating price declines.⁹, ¹⁰ This rule was later suspended in 2007 and replaced with alternative short sale restrictions under Regulation SHO in 2005, which introduced "locate" and "close-out" requirements to address abusive naked short selling.⁸

Key Takeaways

• A long position involves buying an asset with the expectation of profiting from a price increase.
• A short position involves selling a borrowed asset with the expectation of profiting from a price decrease.
• Long positions represent ownership and potential unlimited gains, but limited losses (to the initial investment).
• Short positions carry the risk of unlimited losses due to theoretically infinite price increases.
• Both long and short positions are fundamental tools for speculation, Hedging, and Arbitrage in financial markets.

Formula and Calculation

The profit or loss for both long and short positions can be calculated using straightforward formulas:

For a Long Position:

$\text{Profit/Loss} = (\text{Selling Price} - \text{Purchase Price}) \times \text{Number of Shares}$

For a Short Position:

$\text{Profit/Loss} = (\text{Selling Price (initial)} - \text{Purchase Price (to cover)}) \times \text{Number of Shares} - \text{Borrowing Costs}$

In the short position formula, "Selling Price (initial)" refers to the price at which the shares were initially sold when the short position was opened. "Purchase Price (to cover)" is the price at which the shares are bought back to return to the lender. "Borrowing Costs" include any fees paid to borrow the shares, such as interest on the borrowed securities. These calculations help determine the financial outcome of positions taken in the Stock Market or other asset classes.

Interpreting the Positions

Interpreting long and short positions goes beyond simple profit and loss. A long position typically reflects a bullish Market Sentiment, indicating confidence in an asset's future growth or value. Investors holding long positions are often focused on the underlying fundamentals of a company or market. They benefit from positive news, strong earnings, and general economic expansion. This approach aligns with Value Investing or Growth Investing strategies.

Conversely, a short position signals a bearish outlook. Investors taking short positions believe an asset is overvalued or that its price will decline due to negative news, poor financial performance, or broader economic contractions. Short interest, which is the total number of shares of a security that have been sold short by investors but not yet covered or closed out, can sometimes be an indicator of significant negative sentiment or anticipated problems within a company. While short positions can be speculative, they also play a crucial role in price discovery and provide liquidity to the market.

Hypothetical Example

Consider an investor, Alice, who believes that shares of Company XYZ, currently trading at $100 per share, are undervalued and will increase in price. She decides to take a long position by purchasing 100 shares of Company XYZ.

A few months later, Company XYZ announces strong quarterly earnings, and its stock price rises to $120 per share. Alice decides to sell her 100 shares.

• Initial Purchase: 100 shares x $100/share = $10,000
• Selling Price: 100 shares x $120/share = $12,000
• Profit: $12,000 - $10,000 = $2,000

Now consider Bob, who believes that shares of Company ABC, also trading at $100 per share, are overvalued and will decrease in price. He decides to take a short position. Bob borrows 100 shares of Company ABC from his broker and immediately sells them in the open market, receiving $10,000.

After a few weeks, Company ABC announces a product recall, causing its stock price to fall to $80 per share. Bob decides to cover his short position by buying back 100 shares.

• Initial Sale (borrowed shares): 100 shares x $100/share = $10,000
• Purchase to Cover: 100 shares x $80/share = $8,000
• Gross Profit: $10,000 - $8,000 = $2,000

Assuming Bob also paid $50 in borrowing costs for the shares, his net profit would be $2,000 - $50 = $1,950. This example illustrates how a long position profits from a rising price, while a short position profits from a falling price. These transactions are typically facilitated through a Brokerage Account.

Practical Applications

Long and short positions are integral to various financial activities beyond simple speculation:

• Investing: The most common application of a long position is traditional investing, where individuals or institutions buy assets like Stocks, Bonds, or Exchange-Traded Funds (ETFs) for long-term growth.
• Speculation: Both long and short positions are used by traders to speculate on short-term price movements. A long position seeks to capitalize on anticipated price appreciation, while a short position aims to profit from expected price depreciation.
• Hedging: Investors can use short positions to mitigate the risk of existing long positions. For example, an investor holding a long position in a particular stock might short shares of a related company or an industry ETF to protect against a potential downturn in the sector. This is a common Risk Management strategy.
• Derivatives Trading: Long and short positions are fundamental to Options and Futures Contracts. For instance, buying a Call Options contract creates a long position on the underlying asset's price movement, while buying a Put Options contract creates a short position on it.
• Market Making: Market makers use both long and short positions to facilitate trading and provide liquidity. They may simultaneously hold long and short positions to profit from the bid-ask spread.
• Arbitrage: In Arbitrage strategies, traders might take simultaneous long and short positions in different but related securities to profit from price inefficiencies, often with little to no risk.

Limitations and Criticisms

While long and short positions are crucial for market function, they come with distinct limitations and criticisms.

For long positions, the primary limitation is the potential for capital loss, though this is capped at the initial investment. If an investor buys shares and the price falls to zero, the maximum loss is the amount invested. A common criticism, especially concerning Long-Term Investing, can be related to the opportunity cost if the chosen assets underperform broader market benchmarks over extended periods.

For short positions, the risks are significantly higher:

• Unlimited Loss Potential: If the price of a shorted asset rises, the potential loss is theoretically unlimited, as a stock's price can continue to increase indefinitely. This is in stark contrast to long positions, where losses are capped.
• Borrowing Costs and Recall Risk: Short sellers must pay fees to borrow shares, which can erode profits, especially over extended periods. Lenders can also recall borrowed shares, forcing the short seller to cover their position prematurely, potentially at an unfavorable price.⁶, ⁷
• Short Squeezes: A rapid increase in an asset's price can force short sellers to buy back shares to cover their positions, further driving up the price and creating a "short squeeze." This can lead to substantial losses.
• Negative Public Perception: Short selling is sometimes viewed negatively, especially when it involves companies facing difficulties, as it can be perceived as profiting from others' misfortunes or even actively driving down prices.⁵
• Regulatory Scrutiny: Due to the potential for market manipulation and excessive Volatility, short selling is subject to strict regulations by bodies like the SEC. Abusive practices, such as "naked short selling" (selling shares without first borrowing or arranging to borrow them), are prohibited and have been targeted by regulations like Regulation SHO.⁴ Research indicates that short-selling constraints can lead to price distortions, potentially causing overvaluation in certain stocks.³

Academic research also highlights that short sellers face unique risks, such as the expense of stock loans and the possibility of loan recalls, which can impact asset prices and market efficiency.¹, ²

Long Positions vs. Short Positions

The table below highlights the key differences between long and short positions:

FAQs

What does "going long" mean?

"Going long" means buying a security, such as a stock, with the expectation that its price will increase. It is the most common form of investing, where an investor purchases an asset outright or through a Broker, anticipating a rise in its value over time.

What does "going short" mean?

"Going short," or short selling, means selling a security that you have borrowed, typically from a broker, with the expectation that its price will fall. The goal is to buy back the same security at a lower price later and return it to the lender, profiting from the difference. This strategy is often employed in a Bear Market.

Can an individual investor take a short position?

Yes, individual investors can take short positions, but they typically need a Margin Account with their brokerage firm. A margin account allows an investor to borrow money or securities from the broker, which is necessary for short selling. Short selling also involves higher risks compared to long positions.

What is a "covered" short position?

A "covered" short position refers to a short sale where the seller has already borrowed the shares they intend to sell, or has made arrangements to borrow them. This is the standard and regulated form of short selling, designed to ensure that the shares can be delivered to the buyer. This differs from "naked short selling," where the seller does not confirm the availability of shares before selling, a practice that is generally prohibited.

Why would someone take a short position?

Investors take a short position primarily to profit from an anticipated decline in an asset's price. This can be due to a belief that a company is overvalued, has fundamental problems, or that the overall market or a specific sector is heading for a downturn. Short positions are also used for Hedging against potential losses in existing long positions.