Market Basics: Short and Long positions
Short and Long Positions
What is a long position?
An investor or trader that goes long on a certain share has bought and owns shares of a specific company, anticipating an upward price movement of the stock or the bond. To intensify the risk, and thus potential return on the share, the investor can buy on margin.
What does buying on margin entail?
By buying a share on margin, the investor borrows money from his or her broker, which as a result strengthens his position and commitment towards the share. Any future price fluctuation of the stock will come with greater risk for the investor, as the investment is no longer funded through personal capital, but instead through borrowed money. To trade on margin, a new account is opened with the broker, called the margin account. As is accustomed to any borrowed sum of money, the investor must pay interest over the borrowed money. Hence, any potential loss made on the financial market through poor trading comes with the additional interest costs of the margin account.
What is a short position?
A short position is a move commonly taken by investors to benefit from falling share prices. How this plays out in the stock market is that an investor borrows shares from a broker, with the agreement to return them to the owner at any demanded point. For example, assume a share is trading at 100$. If the investor thinks the price will fall to 80$ in the near future, he will borrow the shares from the firm while they are worth 100$. He will then proceed to sell the shares on the stock market for 100$ per share. When the shares then reach the initially anticipated price of 80$ per share, the investor buys the shares back to give back to the owner, and thus makes a profit of 20$ per share.
As short-selling means that investors will make a profit if the price falls, the profit will be the difference between the price at which was borrowed from the broker and the future price the company is willing to buy them back for, which will hopefully be lower
How does margin trading function for short positions?
Margin trading for short positions functions along the same principle as with the long position. The investor can borrow money from a brokerage house to borrow more shares and thus intensify the profits if the shares fall in price.
How much risk is involved with the borrowing procedures?
A lot. One fundamental issue with shorting is that it sets the stage for open warfare between the investor and the firm. As the firm realizes that the investor is shorting their position with the notion that their share price will perform poorly on the stock market in the near future, any inceptive level of trust is gone. Another key issue with shorting, is that there is no limit to the amount which can be lost by the investor. If the share price rises by a (hypothetical, and completely unrealistic) figure of 50000%, this is the direct loss incurred by the investor. Hence, we recommend to refrain from shorting shares as an average investor.