Understanding Long and Short

Short Selling

Selling something short is a topic that confuses some people. It is important to be comfortable doing it when you are trading, as otherwise you will miss out on a lot of potential profit. Often, shares fall in value more quickly than they rise, so the prospective profits can be greater. Fortunately, it’s not really that difficult, and you don’t need to be scared about it as your broker will take care of the details.

Many beginning traders have a problem with getting their heads around being ‘short’ in a market. Let’s first deal with being ‘long’:

Normally when you buy shares, this is known as ‘going long’ or ‘taking a long position’ in the shares. You would do this in anticipation that the shares will increase in price.

Gong Long: Let’s say you have no position in the FTSE. You decide that the market is going up. You place an upbet with your spread betting firm. You now have a ‘long’ position, since you own a position that you could sell. It is akin to a grain merchant who buys wheat from a farmer. The farmer is ‘long’ wheat and after the trade, the merchant is now long the wheat. All pretty straightforward.

The opposite of this, as you might expect, is ‘going short’, ‘taking a short position’, or ‘shorting the stock’ – these all mean the same thing, and you would do it in anticipation that the shares will fall in price.

Gong Short: Now, let’s say you have no position in the FTSE and decide the market is headed lower and wish to profit from your forecast. You would then place a downbet with your firm. You do not ‘own’ anything, and in order to cancel out your bet, you will need to buy the FTSE at some stage. You were short the FTSE and after buying, you are flat (no position).

Why are investors afraid of short selling?

It is the reverse of our normal experience of purchasing first and selling later. What you are doing is selling the shares before you buy them, and that’s what worries people. You sell the shares at the current high price, wait for the price to drop, and then buy the shares to replace those you sold and profit by the difference in price. You finish up not owing anyone any shares, and with a profit.

So how do you sell what you don’t have? That’s where the broker comes in. The broker either has the shares in his own portfolio, or finds a client who owns the shares, and he “borrows” them for you to sell. When you close your short position and buy the shares, the broker just puts them back, and no one is worse off. Because of the way this works, you cannot short all stocks, but only the more popular ones that have some liquidity.

If you still have a problem with it, imagine you are a magazine publisher and sell annual subscriptions. When you attract a customer, you are selling your magazines for the next year (which haven’t been produced yet) and taking the money upfront. You are ‘short’ your magazines, and the customer is ‘long’, as he/she will be receiving the magazines and could then re-sell them.

A minor point is that if the shares have a dividend payout while you are ‘short’, then the broker will make sure the dividend gets paid to his client, taking the money out of your account. The principle is that the client should have no idea that the shares have been borrowed, and obviously should not lose out because of it. And if the client wants his shares, and the broker cannot find somewhere else to borrow a replacement, there is the remote possibility that he would make you buy them back, whether or not you wanted to yet. But generally the system works well, and you don’t need to worry about the mechanics of it.

Luckily, the online trading platforms of spread betting firms give you a simple either/or choice – are you buying or selling? A simple click on one or the other will give you a trade position. The only thing you need to know is: If you are short and the price declines, you gain. If the price rises, you lose. And vice versa for being long.

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