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The Long and Short of It


Effective market participants are aware of the terms long and short as applied to financial market activity.


Where does the answer lie?
Living from day to day
If it's something we can't buy
There must be another way
--The Police

If you're optimistic (a.k.a. 'bullish') on the prospects of Wal-Mart (WMT), you might buy 100 shares. You would be long the stock. If you're pessimistic (a.k.a. 'bearish') on WMT, you might borrow 100 shares and sell them. You'd be short the stock. Informed market participants should understand the issues related to both strategies.

Effective market participants are aware of the terms long and short as applied to financial market activity.

Long and Short

Todd Harrison recently noted that he was long Sun Microsystems (SUNW) and short International Business Machines (IBM). What did he mean?

Goin' Long: When you buy shares of a company, you are said to be 'long' the stock. Usually, being long is associated with being bullish, since you are holding a security in hopes that its price will move higher over time. Long positions (in stocks, bonds, mutual funds, real estate, commodities...) dominate most investment portfolios.

The Short Side: A less common stance is to be short a security. Short sales are trades made by borrowing shares from someone else and then selling them--in hopes of buying the securities back later (thereby 'covering' the initial sale) at a lower price. Essentially, it's the exact opposite of the long position where we buy first and sell later. Usually, a short sale is a bet associated with being bearish, since you are hoping that the security you have sold will fall in price so that you can buy it back (often referred to as 'covering') cheaper at some later date.

Short Selling Example

Don't feel bad if you're a bit confused by the short concept, since it's more complicated than being long a security. Perhaps the following example will help:

Let's say it's Friday and your roommate has gone out of town for the weekend. You notice that your roomie left behind an iPod--brand spankin' new and still in the box. You have a couple of people over for the evening. One individual spies the brand new iPod, and offers $400 for it now. You're pretty sure that you can buy an identical iPod at the mall tomorrow for $300. So you 'borrow' your friend's iPod and sell it for $400. Saturday afternoon you head to the mall, buy the identical model for $300, and bring it home and place it on your friend's dresser where the original one was.

If you completed this project, you would have executed a 'short' transaction. You borrowed the iPod from your friend and sold it 'short.' You then bought back the iPod, or 'covered,' your short sale at a lower price. A profitable trade, too, since you pocketed $400 - $300 = $100 on the transaction.

Thus, when shorting you sell first and buy back (cover) later. Again, this is the opposite of being long, when you buy first and sell later.

Risk Management

It is often said that being long is much 'easier' than being short. One reason is that financial markets have historically had an upward bias. Stock market exchanges also tend to institute rules that favor long positions over time (the future, of course, may not prove as generous for longs). Another, perhaps more important, reason is that risk of big losses is lower for long trades than for short side trades. In a worst case scenario, a security held long can go to zero, thereby wiping out the investor's position. While that would certainly be painful, the worst case scenario of a short position is wrought with more pain. If a security is sold short and then rises in price, there is theoretically no limit to the losses incurred. Imagine, for example, that right after you sold that iPod short, a huge wave of demand suddenly pushed up prices, and by the time you could buy one to cover your position, iPod prices had risen to $10,000 or more! Theoretically prices could rise to infinity.

Thus, while risk management should be on your mind no matter which way you're positioned, short positions usually require more attention to guard against outsized losses if the position moves against you. Setting 'stops' that cause you to cover your short position if prices rise to a preset level is one way to manage short side risk. Note that Toddo subsequently exited his IBM short side position after rising prices touched his 'stop' price.

Puts: Another Way to Manage Short Side Risk

Another way you'll see many professors on the 'Ville manage short side risk is by purchasing put options rather than by outright shorting of a security. Although the details are a topic for another day, a put option is a derivative that gives the owner the right, but not the obligation, to sell a security at a set price anytime before the expiration of the option. What's good to know here is that put options go up in price as the underlying security goes down in price--roughly mirroring a short position. From a risk management standpoint, a nice thing about owning a put option is that, if prices of the underlying security head to the moon, the put option merely expires worthless. Unlike the unlimited potential losses of a short position, the maximum loss incurred by puts is capped--the investor loses the principle used to purchase the puts but no more. Puts, therefore, can offer an effective means for defining risk when placing a bearish bet.

Something for Bulls and Bears

So, if you're in Hoofy's camp and you see prices heading higher, then you might want to 'get long.' If you want to bang with Boo in anticipation of lower prices, then the short side may be for you. Either way, of course, you'll want to see the other side of the trade and manage risk accordingly.

No positions in stocks mentioned.

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