Personal Wealth Management

A few words today on long and short positions in investing.

Being Long

A long position is the norm in investing.

You buy an asset in anticipation of an increase in value. In future, if the market price rises, you sell the asset and realize the profit. You are long because you own the asset.

For example, you invest $5000 in shares of Microsoft at $25. You are long 200 shares.

Being Short

Short positions are the opposite of long.

A short sale involves selling an asset that is not actually owned by the investor.

The aim is to “sell” the asset at a high price in anticipation of a future decrease in value. To “sell” an asset not owned requires the short seller to borrow the asset from a third party. For financial assets, one’s broker normally lends the assets to the client.

Margin Accounts

The use of a margin account at the brokerage firm is required for short sales.

Note that a margin account involves the broker lending an investor cash for leverage purposes (like a bank loan) or securities for short selling. Margin accounts require adequate reserves  as collateral to cover the open margin position. If funds fall below the minimum margin requirements – which are calculated based on asset type, asset price, etc. – the investor will need to deposit additional cash or securities to cover the margin call. If unable to do so, the broker will sell assets within the account to cover the shortfall.

When the asset price falls sufficiently, the short seller buys it on the open market. The short seller then returns the borrowed assets to the broker and the transaction is completed. If successful, the difference between the higher selling and the lower purchase price is profit.

Short Selling is Risky

Short selling is a risky activity as you do not own the asset. If you are long, your potential loss is the capital initially invested. But if you are short, in theory, your loss can be infinite.

For example, you invest $1000 in shares of Growthco at $10. Because you own the shares, you are long. If the shares rise to $25, you can sell for a profit of $1500. If the company goes bankrupt and the shares fall to $0, the most you can lose is your initial $1000.

But if you decide to short the stock, the risk increases significantly.

A friend of a friend’s second cousin’s girlfriend heard from her hairdresser that SkystheLimit will file for bankruptcy next month. You decide to borrow 100 shares of SkystheLimit from your brokerage house and sell them for $10 per share. You now have $1000 in cash. If the shares fall in price to $1, you will purchase the 100 shares you borrowed on the open market for $100, deliver them to the broker, and net a $900 profit on the deal before commissions and the interest charged on the margin account.

A month later, SkystheLimit did file. Unfortunately, they filed a patent for an amazing new product and not for bankruptcy. The share price immediately rose to $100.

Your broker, concerned about your ability to repay your debt, demands an increase in your account assets to cover the new minimum margin (i.e. margin call). You now need to find available cash or securities to cover the margin call.

You realize that if you buy the shares and close the short position you will lose $9000. Nine times what you invested! But if the share price continues to rise and you do not close the position, your losses will be worse. If the share price rises to $1000, you would lose $99,000.

As you can see, short selling can be very risky. Anytime you have limited potential gain but unlimited potential loss, you should be very wary about investing.

Unless you are an extremely experienced investor, I would not recommend short selling as an investment strategy. And even for experienced investors, I would not recommend extensive shorting and that one should have a sound strategy in place before attempting.