What’s the Difference Between Long Trades and Short Trades?
Going long on a security uses the process that most investors are familiar with. You purchase a security and hold it for a period, hoping for its price to increase during that time. At a later date, you sell the security, hopefully for a profit. Shorting, by contrast, involves selling a security first. To start a short trade, you must first borrow shares from someone else, typically your broker. You then sell those shares on the market. You receive cash from the sale but owe a debt to whoever lent you the shares. Later, you must buy the shares that you borrowed and return them to your lender to repay your debt. When you do this, you complete the short trade. Ideally, you’ll buy the shares for a lower price than you received when selling the borrowed shares, allowing you to keep the difference as profit. Another important difference between long and short trades is the use of margin. You can place long trades on stocks using your regular brokerage cash account. To carry out short trades or short selling, you need to have a margin account with your broker. The margin account allows you to borrow stocks from your broker.
How To Profit
The greatest difference between long and short trades is how they generate profit. Long trades profit when the security involved increases in price. Short trades profit when the security involved decreases in price. For example, if you want to go long on XYZ stock, you could buy 100 shares at $50 each for a total of $5,000 (100 x $50). If XYZ rises to $55 per share, then the value of the shares you own rises to $5,500 (100 x $55). If you sell, you would profit $500 ($5,500 - $5,000) on the trade. If XYZ fell to $45 per share, your shares would be worth $4,500 (100 x $45) and you’d lose $500. If you decided to short the XYZ stock, you’d need to borrow 100 shares from your broker. Now suppose you agree to sell those shares for $50 a share. That would mean you would receive $5,000 (100 x $50) in exchange for those shares. Only, you don’t own those shares. To return the shares to your broker, you would need to buy 100 shares. If the share price of XYZ drops to $45 per share, you can buy the 100 shares for $4,500 (100 x $45). Since you only spend $4,500 but receive $5,000, your profit would be $500. However, if the price of XYZ stock rises to $55 per share, you would need to spend $5,500 (100 x $55) and you’d be spending more than you make on the trade, leading to a loss of $500.
Risk
It’s very important to understand the difference in risk between long trades and short trades. The risk for a long trade is limited. If you buy a stock for $20, the worst-case scenario is that its price falls to $0 and you lose $20. The price cannot be negative, meaning your total risk is the amount you invested. When you short a security, your potential risk is unlimited. Eventually, you must repurchase the stock you sold short. There is no limit to how high a stock’s price can rise. If you short sell a share for $20, it could rise to $40, $100, $100,000, or even higher, so you could wind up losing much more through shorting than through long trades.
Special Considerations for Shorting
One important thing to consider when using a short trading strategy is that the SEC places some restrictions on short sales. Large-scale short sales can drive down a stock’s price quickly, which led the SEC to impose the alternative uptick rule in 2010. This rule states that if a stock’s price drops 10% or more from its previous closing price in one day, short sales will be limited. They can only occur if the stock’s price is above the current highest price at which an investor is willing to buy the stock.
Which Is Right for Me
Long and short trades fill two different niches. If you believe that a stock’s price will rise, go for a long trade. If you think it will fall, a short trade will let you profit from that price movement. However, for most investors, long trades will generally be the better way to go. They’re less risky, and shorting stocks can be complicated. Only consider short trades if you’re an experienced trader and can handle the high risk.
The Bottom Line
Long trades and short trades are two strategies that traders can use to profit from movements in a stock’s price. Long trades are more commonly used by investors who want to buy and hold a stock in hopes that it appreciates in price. Short selling is popular with day traders but exposes investors to much greater risk.
