Most people have a notion of what it means to buy a stock. Purchasing a stock is called taking a “long” position, but fewer understand the process of shorting, or taking a “short” position, in a stock. Both practices can earn traders a profit or result in a loss. While both types of trades can be easily executed via online brokerage software, they differ significantly in their requirements and risks.
Understanding a Long Position
The buyer of a stock establishes a long position. For example, you would say you are “long 100 shares of XYZ Corp.” if you purchased the 100 shares on the secondary market (i.e., stock exchanges) or through an initial public offering. The day you execute your purchase is called the trade date, while the settlement date occurs two business days later, when your money is exchanged for the purchased shares. The price you pay for the shares (plus any commissions and fees) is called the cost basis.
When purchasing stock shares of the same corporation in one or more installments, each installment opens a tax lot with its own cost basis. The sum of your open tax lot cost bases is the overall cost basis of your long position. When you sell some or all the purchased shares, you reduce or eliminate your open long position. You can select which tax lots to close when you sell less than your full long position, or you can let your broker apply default matching rules. Profits and losses on long positions are recorded for tax purposes as having occurred on the trade date, not the settlement date.
The cash you receive from a sale transaction, minus commissions and fees, is called the sale proceed. Your broker offsets your open tax lots against the sale proceeds to determine each lot’s profit or loss. The sum of the individual gains and losses is your overall profit/loss on the sale transaction. Tax lots that represent shares in excess of the number of shares you sold, if any, remain fully or partially open until you sell these shares as well.
Understanding a Short Position
In a short sale, you establish a short position by borrowing shares (for a fee) from a lending broker and then selling these shares in the secondary market. Later, you will purchase the same number of shares in the secondary market and return them to the lending broker, a process known as short covering.
In short selling, you open tax lots by selling the borrowed shares and close the lots when you repurchase the shares. As with long positions, your gain or loss equals the stock’s sale proceeds minus your cost basis, in one or multiple tax lots – it’s just that the sale precedes the purchase. In an interesting wrinkle, you report a loss from a short sale as of the settlement date, not the trade date. However, if you scored a gain from your short sale, you report it as of the trade date.
At any given time, the number of outstanding short shares on the exchange is called the short interest. In other words, as short interest rises, the higher the number of shares that have been borrowed and sold short on the exchange. Short interest creates an implicit future demand for the shares, because each short seller must eventually repurchase the shares and return them to the lending broker. In a short squeeze, share prices rocket higher because of frantic short covering; this is among a short seller’s worst nightmares.
Stock Long vs Short
Generally, you open a long or short position to make a profit. On a long position, you profit when the share prices rise above your cost basis. On the other hand, you earn a profit from a short sale when share prices fall, because you can repurchase the shares for less money than you received from the short sale proceeds you collected earlier.
You’ll notice that on a long sale, you can’t lose more than the original cost of the shares, because a stock’s price cannot fall below zero. Your potential profits on a long position are theoretically unlimited, because the price of a stock can continue to rise without limit (although, as the saying goes, no tree grows to the sky.) The risks are reversed for short sales. Your profits are capped by the $0 floor on share prices, but your losses can mount without limit.
More About Long vs Short
Traders often use short selling to hedge other positions. Hedging is an activity in which you buy or short a security to offset the risk of a long or short position in another security. For example, when trading stocks, you might open a short position in the shares of XYZ Corp. to offset the risk of a decline in the price of the corporation’s convertible bonds that you hold. Hedging is most often done using derivatives, such as options and futures, to offset the risk of long positions, including long stock positions.
Another reason why investors purchase stocks is to collect their dividends. This is a strategy to earn income from the shares, with the hope that eventually the shares will appreciate in value as well. Short positions must pay out the dividends a long position would receive, so short sellers are disadvantaged by stock dividends.
Understanding Margin Requirements
You can open a long position for cash; however, your broker might offer you a margin loan that allows you to borrow up to half the cost of the purchase. Margin is the amount of cash that is held in a _margin accoun_t, which is a brokerage account from which you can borrow money.
Initial margin is the amount of money you must have on deposit in your margin account before you can buy shares on margin. Federal Reserve Board rules require that you have at least 50 percent initial margin in place for a long trade. That is, you must have enough cash on deposit in the margin account to equal at least half of the shares’ market value. Maintenance margin is the amount of cash you must keep in your margin account after purchasing shares on margin; the minimum maintenance margin is 25 percent.
More About Margin Requirements
You pay interest on the loan balance in your margin account. In the margin agreement with your broker, your equity in your position equals the stock’s market value minus the amount of margin you borrowed. If the price of your shares falls a significant amount, your equity in your long position might fall below the broker’s maintenance margin. If this happens, your broker makes a margin call that requires you to increase the cash collateral in the margin account. If you fail to respond to the margin call quickly, the broker will sell (or liquidate) your shares, recoup its margin loan and deposit any excess into your account.
The margin requirements for short positions are more complicated. Your initial margin requirement is 150 percent of the stock’s value, consisting of 100 percent of the cash proceeds from the short sale and another 50 percent in cash that you add to the margin account. The minimum maintenance margin is 125 percent.
You are subject to a margin call if your equity dips below the maintenance margin requirement. You cannot access the proceeds from the short sale until you cover it.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.