Long positions refer to the purchase of securities, such as stocks, bonds and derivative contracts. Short positions occur when investors sell shares, which they borrow from brokers, hoping to buy these shares back at lower prices. Current and anticipated market conditions determine the holding of long or short positions. Short selling requires margin accounts, which allow the use of borrowed funds, but you can hold long positions in either cash or margin accounts.
Long positions benefit from dividends and capital appreciation. Some companies pay regular cash dividends to their shareholders. For example, if a stock pays 25 cents a share in quarterly dividends and its market price is $20, investors are getting a 5 percent return simply by holding the stock. The rate of return is higher if the stock price and dividend payouts increase at a steady rate. Short sellers do not receive dividends. They benefit only if the market price declines. For example, if you short sell 10 shares at $20 and the price drops to $17, you can buy it back at $17 and make a profit of $3 per share, excluding commissions.
The two main types of risk are market and business risk. Market risk involves volatility, which can sometimes lead to sharp price increases or declines. For long positions, market downturns usually mean losses; for short positions, market rallies could lead to frantic short covering as short sellers buy back their shares at rising prices. Business risk for long positions means deteriorating fundamentals, such as declining sales and profit margins. For short positions, business risk means the opposite. For example, if you shorted a stock at $30 because you believed it to be overvalued, you would have to cover your short sale quickly if the stock stages a sudden rally based on rumors about a possible takeover offer. You cannot hold short positions in registered accounts, meaning you may have to pay capital gains taxes on your profits.
You can use options and stop orders to hedge against losses in both long and short positions. A stop order becomes a market order at the stop price. For example, if a long position has gone up from $10 to $15, a stop-sell order with a stop price of $13.50 protects about $3.50 in profits per share. If you shorted a stock at $35, a stop-buy order with a stop price of $37 limits losses to about $2 per share. Options entitle holders to buy -- for call options -- or sell -- for put options -- the underlying shares at set strike prices before expiration. Put options can hedge a long position because they increase in value when there is a share price decline in the underlying shares. Call options could hedge short positions because they increase in value with rising share prices.
Long investors are generally bullish on the markets, while short sellers are bearish, although it is possible for investors to be long on certain securities and short on others. Long and short positions could be in place for a few days or longer. In fast-moving markets, limit or stop-limit orders should prevent order fills outside of acceptable price ranges. However, you run the risk of not filling your orders and potentially locking in substantial losses.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.