What are Long and Short Positions?
Long and Short Positions are two sides of the trade that take place by two or more parties to contract between them, where long position denotes simply long which is the buying of a securities or stock or currency or commodity with the expectation of earning profit and short position denotes the situation where a trader sells security or commodity intending to repurchase it later at a lower rate.
In its truest essence, long and short positions in stocks refer to the techniques used by traders to book profits using different strategies. In a long trade, buying the assets on a low and selling them at an increased price. Contrarily, in a short trade, the trader sells a borrowed stock and buys it back at a lower price.
Table of contents
- Long and short refer to two distinct positions. “Long” involves purchasing assets with the goal of profiting from a subsequent rise in their value, while “short” entails selling assets with the intention to repurchase them at a lower price.
- A “long” position allows investors to buy assets at a reduced cost and later sell them at a higher price, generating a profit.
- In order too execute a short position strategy, the investor borrows shares from an investment firm and subsequently sells them to another investor, aiming to buy them back at a lower price in the future.
Long and Short Positions Explained
Long and short trades are fundamental concepts in trading and investing. It involves traders and investors using different techniques to book profits, ideally in the short run.
A long trade involves buying an asset with the expectation that its value will increase over time. In this scenario, an investor purchases the asset at a lower price and aims to sell it at a higher price, thereby profiting from the price difference.
Long trades are common in bullish market conditions, where optimism about an asset’s future prospects prevails. For instance, if an investor believes a company’s stock will rise, they can enter a long position by buying the stock, with the intention of selling it at a higher price later.
Conversely, a short trade is a strategy where an investor anticipates a decline in an asset’s value. In a short trade, the investor borrows the asset (typically from a broker), sells it immediately at the current market price, and aims to buy it back at a lower price later. The goal is to profit from the price drop.
Short trades are typically used in bearish market conditions or when an investor believes an asset is overvalued. For instance, if an investor thinks a stock is overhyped and will decrease in value, they can enter a short position by borrowing and selling the stock, with the intention of buying it back at a cheaper price.
Both long and short trades come with their own risks and potential rewards, and they play a crucial role in portfolio diversification and risk management. It’s essential for traders and investors to have a deep understanding of these concepts to make informed decisions in the dynamic world of financial markets.
Now that we understand the basics of the concept of long and short position in stocks, let us apply the theoretical knowledge into practical examples to reiterate the intricacies of the concept.
A position determined in the financial assetFinancial AssetFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash. mentions the quantity of an asset owned by the person. A person is considered to have a long positionLong PositionLong position denotes buying of a stock, currency or commodity in the hope that the future price will get higher from the present price. The security can be bought in the cash market or in the derivative market. The course of action suggests that the investor or the trader is expecting an upward movement of the stock from is prevailing levels. when they own the security or asset, which means they have paid the amount to buy the asset or security. For instance, when a person buys an asset or stock, they long for a stock. A long position holder has many benefits of owning this right to long a stock when the price of the asset increases; they can sell it at a higher amount. It gives unlimited profit potential to investors.
When the person sells an asset, they do not own, it is said to have a short position. They will get a profit when the price of the asset falls. However, the seller will sell at a higher price, wait until the price falls, and then repurchase the asset from the market at a lower price to close the position. For instance: for a manufacturer who holds an inventory of aluminum, The risk is that the price may fall. They will protect themselves by selling futures short, and if the price falls, they will lose money as per inventory value but will get a profit or gain from their short positionShort PositionA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date..
Long Position: Buy Low, Sell High
Purchasing assets in a long position is the action of buying shares of an asset expecting the value of the asset will increase over time. It is a strategy where the person buys stocks at a low price and sells them at a high price.
- Say, Mr. X decided to buy 1000 shares of stock in Adidas as he researched the company’s strong fundamentals and growth.
- Mr. X purchases 1000 shares at a closing price of $80 per share, which means 1000 * 80 = 80000.
- One year later, the stock’s price is $85 per share, a hike of $5 per share. The value of Mr. X’s investment would be: 1000 * 85 = $85000
The long position will book the gain of $5000 by Mr. X by using the Buy low Sell high concept.
Short Position: Sell High, Buy Low
It is the technique by which investors expect that the value of an asset will decrease for a short duration, perhaps in the next few weeks. In this process, the investor borrows the shares from the investment company to sell to another investor. Companies have many shares on hand or borrow from other companies to provide loans to an investor. However, an investor returns the shares they borrow. The main intent is to sell the stock at a higher price and then buy it back at a lower price.
Short-selling in the markets of Unites States hit $1 Trillion in 2023. The market had already recorded a hefty $138 at the start of the year. However, some $110 billion were added to the tally due to the increase in prices of the stocks being short-sold.
It is important to understand that rising prices meant a market-to-market loss for short-sellers. These losses have been more clearly visible in stocks that tanked in the previous year due to global economic cues and the war between Russia and Ukraine.
A year later, when the market has recovered more than 17 percent, those stocks are showing clearer signs based on the total return basis through the first six months of 2023.
Despite having various risk adjusted rewards, this type of investing and trading is not free of risks. Let us understand them through the points below.
- Long positions risk potential losses if the asset’s value falls instead of rising as anticipated. The investment could decline in value, leading to capital loss.
- Short positions involve the risk of unlimited losses since an asset’s value could rise significantly, forcing the investor to buy it back at a higher price.
- Short squeezes, where many investors rush to cover their short positions, can amplify losses.
- Both positions are exposed to market volatility, timing errors, and unexpected events that can impact asset prices, making risk management and thorough analysis crucial for successful trading.
Advantages & Disadvantages
Let us understand both the extremes of this form of trading and investing through the advantages and disadvantages below.
- It is a hedging tool that reduces the overall market exposure of a portfolio.
- The investor acquires an arbitrageArbitrageArbitrage in finance means simultaneous purchasing and selling a security in different markets or other exchanges to generate risk-free profit from the security's price difference. It involves exploiting market inefficiency to generate profits resulting in different prices to the point where no arbitrage opportunities are left. option through this position.
- It provides liquidity to the funds and conveniently adjusts the market’s risk.
- Exposure to short and long positions can reduce a portfolio’s overall volatility.
- These two positions allow the holders to mitigate the risk with overall production value.
- Long positions can tie up capital for extended periods, limiting opportunities for other investments. If the asset’s value drops, losses can occur.
- Short positions carry the risk of unlimited losses if the asset’s value rises substantially, requiring buying back at higher prices.
- Borrowing costs for short positions can also add up. Both strategies are susceptible to market fluctuations, potentially resulting in missed profit opportunities or unexpected losses.
- Emotional biases can influence decision-making in both long and short positions, leading to suboptimal outcomes.
Long Position vs. Short Position
Both long and short positions in stocks are exactly opposite to each other. If an investor has opted for a long position, it means that an investor owns the shares of stock. By contrast, if the investor owes the stocks to someone but not the stock owner, it is considered a short position. In the case of options, holding or buying a put or call option is a long position; the investor has the right to buy or sell to the specified person at a certain price. Conversely, writing a call or selling or put option is considered a short position where the writer must sell or buy from the long holder or buyer of a certain option. Long positions are considered to be less complicated as compared to short positions.
Frequently Asked Questions (FAQs)
Long and short positions are fundamental concepts in trading and investing. A long position involves buying an asset with the expectation that its price will rise, enabling the trader to sell at a profit later. A short position involves selling borrowed assets with the anticipation that their price will decline, allowing the trader to repurchase them at a lower cost. These positions offer traders the flexibility to profit from both rising and falling markets.
In order to take a long position, you buy an asset through a broker, holding it in your portfolio with the hope of selling it at a higher price. To take a short position, you borrow and sell assets, aiming to buy them back at a lower price later and return them to the lender. This process involves margin accounts and carries higher risk due to potentially unlimited losses if the asset’s price rises.
Yes, one can hold long and short positions simultaneously, but they are typically in different assets. This is known as a “hedged” position, where one position offsets potential losses in the other. However, simultaneously having long and short positions on the same asset doesn’t make practical sense, as one position would negate the other’s gains or losses.
This has been a guide to what are Long and Short Positions. Here we explain its examples, risks, and advantages, and compare long and short positions. You can learn more from the following articles –