In the financial industry, it is common to hear professional traders argue over the buying and selling of stocks, with many referring to them as “long” or “short” stocks.
This is basically a fancier way of expressing whether the investor thinks the price of the stock will go up or down. In this article, we will teach you all you need to know about the difference between short and long positions.
Understanding Long and Short Derivatives
To begin, let’s get a solid grasp on the meaning of the term “derivative.” A derivative is the same thing as a derivative contract, which is an agreement between two parties. One party is said to have a short position in the derivative, while the other side holds a long position.
Contracts known as derivatives have values that are generated from the values of underlying assets such as stocks, commodities, or money. For the sake of this study, we will use stocks as a representative example of a derivative.
Certain types of derivatives may be used in the process of hedging, which is another term for protecting oneself against the risk associated with an investment. In addition, derivatives may be used for speculative purposes, such as speculating on the eventual value of the asset or developing creative solutions to problems with exchange rates.
Long Trades
Long trades seek to profit from rising stock prices, whereas short trades seek to profit from falling stock prices. Long trades are frequently referred to as “bullish” in stock lingo. Short traders, on the other hand, are referred to as “bearish.“
A long trade is usually simple; all you need is enough money to pay for the shares and the broker’s commission. For example, being long 100 shares of Microsoft means you purchased 100 shares with the intention of profiting when the stock price rises. Your potential profit is limitless, yet your maximum potential loss is 100% because the stock price cannot fall below $0.
Short Trades
Short trades, also known as short selling, are trades that seek to profit from a stock’s price decrease. Short trades are typically more complicated than long trades. To short sell a stock, a margin account, which has unique restrictions and borrowing rights, is required.
This is due to the fact that the investor technically borrows the shares from the stock brokerage, sells them, and then attempts to purchase back the same shares at a lower price with the purpose of returning the borrowed shares and benefiting from the difference. However, if you are correct in your estimate of Apple’s stock and it falls to $10, you will have made a profit of $40 when you return the borrowed shares.
Long positions in companies whose stock prices an investor anticipates will increase in the future should be held by the majority of investors. This demonstrates that it is an excellent method based on evidence that comes from the past. Short-selling stocks can also result in profits, but you should keep in mind that this strategy involves a much higher degree of risk due to volatility and other factors.
Summary
The value of a derivative is dependent on that of an underlying asset. Options and futures are two prominent types of derivatives. Being long on a derivative indicates that an investor has purchased the derivative in anticipation of a price rise. However, being short on a derivative indicates that an investor or trader is selling a derivative in anticipation of a price decrease.
Long trades are simpler to execute, and the potential reward is almost unbounded, but you can only lose as much as you have spent. Short trades carry a considerably higher level of risk since the amount of profit you may make is limited while the amount you stand to lose is limitless.
Takeaways
- In the financial industry, it is common to hear professional traders argue over the buying and selling of stocks, with many referring to them as “long” or “short” stocks.
- Contracts known as derivatives have values that are generated from the values of underlying assets such as stocks, commodities, or money.
- Certain types of derivatives may be used in the process of hedging, which is another term for protecting oneself against the risk associated with an investment.
- Long trades seek to profit from rising stock prices, whereas short trades seek to profit from falling stock prices.
- A long trade is usually simple; all you need is enough money to pay for the shares and the broker’s commission.
- Short-selling stocks can also result in profits, but you should keep in mind that this strategy involves a much higher degree of risk.
