What’s fascinating about the modern financial world’s creations, among others, is making money from short and long positions in stock markets.
Two popular investment options are in wide use to increase returns. A long position refers to an investor buying and holding a company share, while a short position denotes an investor selling a company share he does not own.
However, you can profit from a long or short position if the share price aligns with expectations and vice versa. An understanding of the mechanisms gives you clarity in choosing the right one.
Short Position vs. Long Position
A long position holder is optimistic about a stock’s price in the future. He buys a stock or call options and waits for the price rises. A short-stock position holder is pessimistic about a stock. He sells it to lock in profits before the share price slides in the future.
At a Glance
|Pessimistic about a lower price of a stock||Optimistic about a rise in a share|
||Buy stocks or call options|
Use of funds
||Use of an investor’s funds|
Option types Used
|Short call options||
Long call options
What is a Short Position?
A short position is an investor short-sells a stock and makes money when a stock price falls. He expects a share price will fall and intends to profit from the decline by short-selling a stock.
What Happens When You go Short?
You borrow stocks from a brokerage firm and sell them in the market. When the stocks slide in price, you repurchase them at lower prices and return them to the brokerage. The differences between selling and buying prices, excluding expenses, become the profit you will keep.
How Long Can You Stay in a Short Position?
You can maintain a short position if you fulfil requirements set by a brokerage lending you securities for short selling.
A typical broker requires two requirements for an investor:
- Margin requirements: You should maintain a maintenance margin requirement, e.g., a minimum amount of 25% of the equity or above in your margin account. A broker may initiate a margin call to fill the gap, or you may face a forced liquidation of the sale of securities if the requirement bar is below 25%.
- Interest requirement: Once in a short position, you are liable to pay interest accrued from borrowed securities. The costs become burdensome in a rising interest rate environment.
Case In Point
Mr. Chen opens a margin account to short-sell stocks with a broker. Thinking Google stock(Goog) is overvalued, he deposits USD2,475 into the account to margin-trade the share.
He expected the stock price would fall and borrowed 100 shares of Goog to short-sell from the broker when the then-current price was $99. Mr. Chen had to pay the interest of annualized 6% for the amount borrowed.
Now, after 15 days, the share price falls to $80 per share, and he repurchases it at a price in the market. The profit he has made is the following:
Mr. Chen calculates the profit: the sale amount – the purchase amount – interests(principal: 100 x $74.25(maximum amount of loan of 25% initial margin based on the price of $99):
The profit: $99 x 100 – $80 x 100 – $7,425 x 6% x 15/365 = $1881.69
He makes $1,881.69 or $18.82 per share from the trade, costing $2,475 or $24.75 per share. A 76% return from the trade!
What is a Long Position?
An investor is in a long position when he expects a share price to rise and buys the stock. The last thing he should do is wait for the stock to reach the target price and sell it for a profit over its purchase price.
Other long-position strategies
You can also invest in other long positions to profit from rising stock prices. Option investing is one of them. A long stock call option allows an investor to buy an underlying asset – a stock, at a strike price.
The option is in a “not the obligation” mode for the buyer when choosing to exercise the right, but an option seller (writer) is obliged to sell the asset if the investor requires so.
Another strategy is the long-put option. A long put option allows an investor to sell a stock to a put option seller (writer) at a specified price if the then-current underlying asset’s price is below the price on a put option. An investor uses a put option to protect asset value from falling.
On the other hand, option sellers of long and short positions can collect option premiums as income if investors do not exercise their rights to buy or sell.
Both long and short positions have their returns and risks involved in the process. A short position offers much higher returns and risks than a long position. You should review your risk appetite and rules issued by the Securities and Exchange Commission to protect you from unsuitable investments.
- Investors expecting a rise in share price have a long position on a stock or a call option.
- Investors expecting a slide in share price has a short position on a stock or a put option.
- A short position has a higher return and risk than a long position.