The LONG and the SHORT of it.
I got asked a question on the platform the other day.
What does LONG and SHORT mean? And how does it work here on eToro and also with real stocks?
By the time I got into writing my response I realized word limit was going to become a factor, so decided to instead to write an article on it
The terms Long and Short essentially in very simplistic terms, mean buying and selling.
Forgive me for oversimplifying I know many of you are going to say WRONG! to that statement and the next bit also, but bare with me and we will get there by the end of this article. "Long" is when you buy an asset in the belief that the value of that asset will appreciate. Since markets as a general rule gradually climb over a much greater period of time than when they fall, the phrase is derived from "long term". So to go long or to establish a long position means to buy. "Short" is when you sell asset in the belief that the value of that asset will depreciate. Since markets tend to fall much more sharply and quickly than they rise, the phrase is derived from "short term". So to go short or establish a short position means to sell. However it is not that quite that simple. On eToro we trade something called a CFD (contract for difference) we don't actually own the real asset. A CFD is a derivative which means the price is only derived from the value of the underlying asset. So when we purchase the CFD to buy (GO LONG) Apple for example, we are betting the price will go up if it does and we then close the trade in profit, the broker (eToro) pays the value of the difference into our account, hence "contract for difference"(CFD). If the price went down in this case and we closed at a loss we pay the broker the difference. The exact opposite is true when we purchase the CFD to sell (GO SHORT) Apple In this case we are betting that the price will go down. This is some what different from how a short works when dealing with real stocks. So lets look at how going LONG or SHORT would work when dealing with the real stock/asset. First lets just quickly cover the very simple transaction of going LONG when dealing with real stocks. Going LONG simply means we buy shares of a stock at one price in the belief the price will go up, then we sell those shares at that higher price pay the broker his fee and walk away with the profit that is how simple going LONG in the real world is. So how do we short a stock when it is not a CFD but the real stock/asset, this is somewhat more complicated. So here is a simplified example. Lets say I'm dealing with a stock broker and I want to SHORT stock in Apple . I call my broker and tell him/her that I want to short lets say 100 shares of Apple. Now I don't currently own the shares of course as that would be going LONG. So in this case the broker rounds me up 100 shares, most likely from other peoples accounts or brokerage holdings and gives them to me. I then take those shares and immediately sell them at the current market price which today is $175, 100 x $175 = $17,500 woohoo! Free money I'm rich! however here is the catch, the broker needs there 100 shares back in order to conclude the transaction. So in order to make a profit I need to buy the shares back at a lower price than I brought them. So lets say I was right in my hunch and the price falls to $150 and I buy the 100 shares back 100 x $150 = $15,000 I then give the 100 shares back to the broker and the SHORT trade is closed, and I have made $2500 by selling and buying back shares that were never mine in the first place. Of course it would be $2500 minus the brokers fee for opening the short But I would still have a very nice profit. Now I'm sure many of you astute readers have all ready realized something very important about SHORTING, and that is how it is massively more risky than going LONG.
Why? So lets say I go long on stock Y and buy 100 shares of it at $10 a share, costing me $1000, then like a good little trader set the stop loss at 5%. The trade goes against me and hits my stop loss oh well I've lost $50 no big deal. If for whatever reason I didn't set a stop loss my maximum exposure is $1000 and I can lose it all but only if the stock goes to 0. Now lets say I want to go short on stock Y the broker gives me 100 shares I sell them at $10 a share, cool! I'm up $1000. Yeah but now Ive got to buy them back, but instead of going down the price goes UP! I should of course set a stop loss at 5% also, so if the price climbs I automatically buy the shares back and take the loss. But what if I don't and instead decide to wait and hope the price will go down well in this case my maximum exposure isn't $1000 like in the LONG trade but it is in fact (queue dramatic music) UNLIMITED! Just think of the potential nightmare scenarios that could occur. For example the stock could announce a secretly negotiated merger or buyout and could quadruple overnight now the stock is $40 a share and to buy back the 100 shares I owe the broker will cost me $4000 I'm out $3000 and I haven't even paid the bastard his commission yet. But of course it is possible the stock could go higher and higher and higher hence my exposure is potentially unlimited. But sticking with the previous example of the stock jumping to $40 and I now need to pay $4000 to buy the shares back. Well what if I don't have $4000 to buy the shares back? Oh well in that case this could just be the start of a whole series of much bigger life problems, but putting it simply I'm buggered!
A short trade not managed properly can and in some cases actually does lead to RUIN! So there you go my friends that is the LONG and the SHORT of it so to speak.