Quite simply, you can either be long or short in the stock market. If you are long, you are bullish, meaning you expect the market to go up. If you are short, you are bearish, meaning you expect the market to go down.
If you are long in the market, you typically purchase stocks. You own those stocks, and you believe the stocks will go up. If the stock goes up, you make money, and if the stock goes down, you lose money.
You can also be long in the stock market through derivatives, primarily options. If you purchase call options on the open market for a premium, you are effectively betting that a stock will hit at or above a predetermined strike price. You can also sell puts, such that you insure someone against a loss, and receive a premium on each put contract you sell on the open market.
If you are short the market, you typically short-sell stocks. To short-sell a stock, one must first borrow a stock or another security (usually from a brokerage, such as Charles Schwab, Fidelity, etc.), then sell it at the market price, and then buy it back after it has fallen and return it to whoever you borrowed from initially. Your profit as a short-seller is the difference between the total value of the share you borrowed and sold and the total value of the shares you bought back to return to the borrower.
One can also be short the market through options. One can sell call options on the open market, and receive a premium for each. Thus, the investor is betting that the stock on which he sold call options will not reach the strike price, and the options will expire worthless. One can also buy put options as a safeguard against any loss. The investor will pay a premium to have their losses insured.
Inherent Risk in Long vs. Short Trades
If you examine more closely, the potential for loss is much greater with a short position. The maximum you can lose with a long position is the price of the stock at the time you buy it. However, this is not true with short positions.
Suppose I purchase stock A for $20. If the stock drops to $0, I’ve lost the maximum amount possible, $20 per share that I’ve purchased. Now suppose, I short stock B when it is at $20. Now, suppose stock B turns bullish, and it goes up to $100. I’ve now lost $80 per share, as I lose on the stock if it goes above the price I shorted it at. Imagine if the stock went up to $1,000. That would be a loss of $980. Theoretically, the loss potential for a short position is infinite.
Additionally, as I described before, you must borrow shares from an entity such as your broker to short a stock. This involves using a margin account, and you will most often have to pay interest on the stock. Thus, when you short, you must be nearly certain that the stock will go down, especially if you are taking a large short position.
Hedging Against Risk
The short position is not completely useless, however. A risk-averse investor tends to use portfolios called Long/Short Portfolios. This means that they are protected from large amounts of risk associated with their investments. They have a certain amount of their portfolio that is bullish, through long positions. Then, they have another portion of their portfolio that is bearish, through short positions.
Now, the split between long and short positions does not have to be 50%-50%. If the investor believes that the stocks have a higher probability of going up, then they could have 70% of their portfolio dedicated to long positions, and 30% dedicated to short positions. Thus, their risk is controlled. However, this also stifles their maximum profits, as if the market does end up going up, then they will lose some money on the 30% of their portfolio that is short.
When investing, it is always important to understand at a fundamental level whether an investment is long or short in your portfolio. History says it’s always best to take long term bullish positions in the market and economy. Shorting stocks is risky and its something that more experienced investors typically do. Ultimately, no matter how you comprise your portfolio, it’s crucial to understand which parts of it are long and which are short.