The long & short of trading
The long & short of trading
How do people make money on Ebay or any other marketplace? Simple—“buy low, sell high”—the mantra that means to buy something and sell it back later for a profit. The same goes for trading. But if you end up spending more on your trade than what you sold it for, you’ve got a loss.
In trading, when you own something—whether it’s stock, options, etc.—you’re “long.” If you own shares in, say, the theoretical company, Tiger, Inc., you could level up your lingo and say you’re “long Tiger.” Anything you’re long is something that you generally want to go up in value, so you can sell it for a higher price and nail that whole buy low/sell high strategy. That’s true for any investment.
In trading, risk graphs are used to visualize the potential profit or loss of a trade. If you graph out the profit and loss (you also might see this referred to as “P/L”) of a long stock position, it looks like this:
Let’s start with stock—your risk is directly proportional to the number of shares you own. If you own 10 shares of stock in our theoretical company Tiger, Inc., you will make or lose $10 for every one dollar move the stock makes. Own 100 shares? Then it will be a $100 gain or loss for every one dollar move of the stock. The more shares you own, the more risk you take on. It’s as simple as that.
Flip the script
You can also turn the buy low/sell high thing on its head and do the sell part first, then try to buy back later at a lower price. This is called “shorting” or “selling short.”
Why would you “short” something? Well, if you think a stock’s price has peaked and its price could fall, shorting is a way to potentially make money as the stock goes down. (Note: Robinhood Financial does not allow you to short a stock, but it’s a strategy worth knowing about.)
Essentially, “shorting” something simply means you’ve sold something you don’t own—which can take new traders by surprise. When you sell something that you’re currently long, you’re not shorting. You’re just “selling to close” your trade and you don’t own that investment anymore.
To short a stock, your broker lends you someone else’s shares to sell in the market. The mechanics behind shorting options differ a bit, but the end goal is the same—you sell high first, then try to buy back cheaper (note: Robinhood Financial does not allow you to short uncovered options). Whatever it is that you sell short has to go down in value for you to profit. Otherwise, you will incur a loss.
Let’s come back to our example with Tiger, Inc. You seek to make money shorting Tiger, Inc. stock when the stock price drops. When you buy it back at the lower price, you’ll lock-in your profit and you’re not short the stock anymore. But, you’ll lose money if the price goes higher since it’ll cost you more to buy it back than what you collected by selling it. It’s important to understand that when someone shorts a stock, they have theoretically unlimited risk since there’s really no limit on how high stock prices can go.
If you graph out the P/L (like we explained above, P/L refers to profit and loss) of short stock, it looks like this:
To recap, here are some of the basic tenets of trading to keep in mind:
- When you buy something, you’re “long” that something, and you want it to go up in value. Stock? You want it to go up. Options? Same. You want them to go up in value so you can sell them for a profit.
- Whenever you “short” something, you want that something to drop in value. There’s only one way to buy something for a lower price, and that’s to have it drop in value.
- When you buy something, the most you can lose is what you paid for it. If you buy the stock of a major company, it’s unlikely you’ll lose the whole thing (but it does happen). It’s also unlikely that the stock will double or triple in value in a short period. With options, however, it’s much easier to lose the entire value of your trade as an option is typically a fraction of the stock’s cost and has an expiration date (we’ll discuss this in the next article). Yet, options can also generate large gains, relative to their price. One caveat here: if you are buying stocks on margin, you can lose more than your initial investment. On the contrary, you must pay cash for long options, and cannot buy them using margin.
- When you sell something “short,” the most you can make is what you sold it for. Since the value of both stocks and options can only drop to zero, the amount you can profit when “shorting” is limited to the sale price. However, it’s really important to note that the potential risk can be extreme in this situation, because the stock can theoretically rise forever.
Next up: A big, little primer on options
Any hypothetical examples are provided for illustrative purposes only. Actual results will vary.
Content is provided for informational purposes only, does not constitute tax or investment advice, and is not a recommendation for any security or trading strategy. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results.
Options trading entails significant risk and is not appropriate for all customers. Customers must read and understand the Characteristics and Risks of Standardized Options before engaging in any options trading strategies. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount.
Short selling and margin trading entail greater risk, including, but not limited to, risk of unlimited losses and incurrence of margin interest debt, and are not appropriate for all investors.
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