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Long and short in trading

Author: Thomas Brock
13 feb 2024
Long positions on the stock exchange is a classic investment approach, when a trader purchases assets with the expectation of their future growth in value. In other words, a trader invests in securities, commodities or currencies, expecting their price to increase for subsequent sale at a profit.
Opening a long position starts with analysing the market and choosing a suitable asset. A trader can base his decision on different methods of analysis: fundamental (studying economic indicators of a company or country), technical (analysing charts of price movements) or a combination of both approaches.

After selecting an asset, it is necessary to determine the optimal moment to enter the market, i.e. to buy the asset. The trader then places a buy order through his broker at the current market price or places a pending order at a predetermined price. Once the buy order is executed and the assets are actually purchased, the process of managing the open long position begins.

The potential benefit for the trader is to receive income from the difference between the purchase price and the subsequent possible increase in the value of the asset. If the forecast is correct and the value of assets increases, the trader can close his long position by selling the same assets at a new, higher price.

In the context of potential income, it is also necessary to consider the possibility of using leverage - a margin trading tool that allows market participants to operate large amounts of capital with minimal own investments. Leverage can significantly increase potential profits; however, the risk of loss increases proportionately.

Successful trading with long positions involves not only choosing the right time to open and close a deal, but also hedging skills - creating protective operations to minimise losses in case market conditions do not change in your direction. This may include the use of stop-loss orders (automatic closing at an undesirable price reached), portfolio investing (dividing capital between different types of assets) and other risk management strategies.

Short positions: this is a way of earning money on a decrease in the value of an asset. Unlike a long position, where a trader earns on the growth of prices, a short position allows you to profit on their decrease.
The principle of a short position is as follows: a trader borrows assets from a broker with the obligation to return them in the future. These assets are then immediately sold at the current market price. If everything went according to plan and the price of the asset actually fell, the trader buys them back at a lower value, returns them to the broker, and keeps the difference between the sale and purchase price.

The process of opening a short position begins with the selection of a suitable instrument. Ideal candidates are overvalued assets or those whose value is expected to fall due to certain fundamental factors. After selecting the right asset, a request must be made to the broker to borrow these very securities or other instruments for subsequent sale.

When concluding a short transaction, it is necessary to keep in mind the potential risks. In case of erroneous forecasting of the direction of price movement of an asset, it may increase instead of the expected decrease. In this case, in order to close the short position you will have to buy back the asset at a higher price than it was sold initially, which will lead to losses.

One of the key risks of a short position is the fact that potential losses may not be limited; if the price of an asset rises indefinitely, the technically possible size of losses will also increase until the trader closes his short (while in longing operations the maximum loss is limited to the initial investment).

To minimise these risks, various hedging and risk management strategies are used: the use of stop-loss orders to automatically close an unfavourable position when a predetermined undesirable price is reached; the use of options as insurance; capital allocation between different types of investments and so on.

Important conditions for successful shorting operations are deep analysis of the state of the market or companies chosen for speculation (fundamental analysis), as well as the use of information about price changes (technical analysis) to determine the optimal entry and exit points.

Short positions: principle of operation, opening process and possible risks.

A short position is riskier than a long position for several reasons. Firstly, the potential losses when shorting are theoretically unlimited. If a trader takes a long position (long) and assets lose value, the maximum loss is limited to the amount of the investment. However, when opening a short position (short), the value of the asset can grow indefinitely, which leads to an unpredictable amount of possible losses.

The second peculiarity of a short position is timing: a short position requires a precise time of entry and exit from the transaction, as asset prices can change very quickly and unpredictably. Holders of long positions have more freedom in making decisions to sell the asset due to the absence of time pressure.

It is also worth considering the interest rates for lending assets when opening a short. Traders need to borrow the asset from a broker before selling it, which may incur additional interest costs for borrowing or securities.
Another factor is the 'short squeeze', which occurs when a mass closing of short positions causes the price of an asset to rise rapidly. This can lead to even greater losses for investors in short positions.

Finally, the emotional aspect: the mental and financial strain of maintaining a losing short position can be significant for the trader due to the constant sense of uncertainty and the possibility of large losses.

To minimise these risks, traders use various hedging and risk management strategies: stop losses to automatically close an unfavourable position when a predetermined level is reached; the use of options as a form of insurance; portfolio diversity by allocating investments to different asset classes; and strict adherence to trading rules and maintaining discipline.

Why a short position is riskier than a long position

In the world of stock trading, it is common to use allegorical animal images to describe the behaviour of market participants. Two of the most famous symbols are "bulls" and "bears". Their struggle symbolises the main movements in the financial markets, where each side seeks to give its own direction to asset prices.

Bulls symbolise the optimism of traders and investors, the belief in the growth of asset values. They "aim" to buy assets in the hope of further price increases, which will allow them to sell these assets at a higher price. The name comes from the way a bull attacks - it tosses the opponent upwards with its horns, which is compared to the movement of a rising market.

Bears, on the other hand, are pessimistic about future market developments. They expect the value of assets to fall and capitalise on this by selling borrowed shares or other instruments with the expectation of buying them back later at a lower price. A bear attack is a powerful downward paw strike from above, which is associated with downward price movement in a bearish trend.

These terms are widely used to characterise the general state of the financial market:

A bull market is a period of prolonged upward price movement in most assets;

A bear market is characterised by a general downturn and decline in value.

Competent reading of marketing indicators helps traders to determine the current "weather" on the stock market - the time of bulls or the time of bears. This knowledge is critical when making strategic trading decisions: opening long or short positions in the respective assets.

Understanding the behaviour of "bulls" and "bears", it is necessary to study not only basic economic factors, such as corporate reports of companies, changes in interest rates of central banks or news reports from the political field; but also to pay attention to the psychology of players - fluctuations in investor optimism or pessimism.

You also need to keep in mind techanalysis: supply and demand charts, support and resistance charts, trend reversal patterns - all of which can indicate either bullish dominance or bearish dominance.

Ultimately, the combination of all these techniques can help traders choose the right strategy for each particular economic environment, whether they are longing when the trend is bullish or shorting when the bear begins to dominate.

Who are bulls and bears

Before diving into the comparative analysis of long and short positions, it is worth understanding the conditions under which traders decide to open a particular deal. Long positions are most often chosen when optimism prevails in the market and there are reasons to expect growth in asset prices. In such cases, traders expect the economic situation to strengthen, positive changes in the activities of companies or the release of favourable news.

In the context of short positions, the decision to open them is made on the assumption of falling asset prices. This can be caused by various factors: negative economic statistics, corporate scandals or a general downtrend in the market.

Risk management is a key point in any trader's strategy. When working with long positions, the main tools to control the level of losses are setting stop-loss orders, which automatically close the position when a certain level of losses is reached. For short positions, stop-loss orders are similarly used, but they have their own specificity because of the unlimited potential for possible losses; various forms of hedging can also be used here to offset potential losses.

An example from trading practice can be the following: let's imagine that there is information about the imminent release of a positive quarterly report of company X. A trader can take a long position before the release of the report in anticipation of the growth of the share price after the publication of the data. If there is information about possible financial problems of the company Y, it is possible to go short before the release of this information to the wider market.

It is also worth remembering about margin trading as one of the methods of working with both long and short positions: it is a way of gaining access to a large volume of assets using only a partial deposit (margin collateral). By engaging in margin trading, a trader can significantly increase both his potential profit and his potential loss.

Finally, it is worth emphasising the importance of analysis - whether fundamental or technical - which is the basis for any type of investment and plays a significant role in making the right trading decisions.

Comparative analysis of long and short positions: terms of use, risk management strategies and trading case studies.