What is long and short in trading?

What is long and short in trading?

How trading works
Photo by @FotoArtist

Our previous lesson introduced the concept of long and short in trading. Going long means that your trade moves into profit when the price rises. Going short means that your trade becomes profitable when the price falls. 

If you trade forex markets you’re always trading currency pairs. This means that you are always “long”  on one currency and “short” on the other. 

Long and short origins

The origins of the terms “long” and “short” in trading go back hundreds of years and are steeped in stories. There are elaborate explanations and a simple one.

  • Tally sticks recorded debt in medieval Europe. The shaft was split into two uneven parts. The two parties to the transaction (buyer and seller) each took a piece. The borrower held the shorter piece called the “foil”. The longer part  was called the “stock”, and was held by the lender who was providing the funds. The terms “long” and “short” identified which side of the trade you were on. 
  • Another use of the term “short” relates to the following example. If trader A thinks the price of his stock is high, they may sell it to B who buys it because they believe the price of the stock will rise. A is then short of that stock but will only want to buy more if the price declines allowing him to make a profit. A is a bear because they are ‘bearing’ the price down. B is a bull because they’re ‘tossing’ up the price.
  • A more straightforward explanation of “long” and “short” is this. A price can only fall to zero, that is it can fall by only 100% of its current value. But a price can increase multiple times above the current price, say 1000%. In effect, the price drop is shorter than the potential price rise.

What are long and short positions in trading?

Long and short trades can also be referred to as “buy and sell” or “bid and ask”. These are similar terms to describe the same action. Those holding long positions in a financial market stand to gain from a rise in the price of a financial instrument. Those holding short positions will profit from a fall in the price.

In the stock markets:

  • A long trade is buying in the hope of selling at a future higher price and banking a profit;
  • A short trade is borrowing a stock, selling the stock and then buying the stock back to return it to the lender. The investor is betting that the stock they sell will drop in price to allow them to make a profit

So, when traders short stock markets, they don’t actually buy their initial stock. Instead, they borrow funds to cover their opening position and hope to buy at the lower price.

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What do long and short positions mean?

In the forex markets, taking long and short positions Ithrough spread betting or trading CFDs) is more simply defined. If you take a long position, then you hope the market will rise. If you have a short position, you hope it will fall. Long = buying the market. Short = selling the market.

Remember, in the forex market if you take a short position you’ll be trading a derivative. This means you don’t own the underlying asset but you are simply betting on the direction of the price of the asset. There is no worry about committing to buying the stock. Your broker will look after the process by offering you leverage based on the funds and deposit (margin) you have in your trading account.

What is a long position?

By contrast, if you take a long-position trade or investment, you are buying an asset like shares, forex pairs, cryptocurrencies etc in the hope that the price will rise. You plan to sell the security in the future at a profit. 

Investors who operate long term trading plans, buying and holding shares in portfolios or engaging in long term forex trading are described as being long. Typically, these investors don’t short markets, but they may cash out if the price falls to a certain level.

Long term forex trading is sometimes called position trading. If a trader is long on specific currency pairs over a period of say, months as opposed to days, they are classed as investing in forex markets, rather than trading them.

What is a short position?

Short selling is an investment or trading strategy which speculates and attempts to make money on the decline in the price of a stock or other security.

With a short position, a trader borrows shares of a stock or another asset which they believe will decrease in value by a set future date; the expiration date. The investor eventually sells these borrowed shares to buyers willing to pay the market price.

You hold a short trading position if you’re betting the market will then fall, enabling you to buy back the shares at a lower price, returning them to the lender and enabling you to make a profit. In a market such as the forex, when you trade on a platform like MT4, you can hold these short positions for seconds or weeks.

 

Long and short
TradingView Screenshot

 

How to go long and short on the markets

Going long and short on markets through your broker as a retail trader is a simple process. On a platform such as MetaTrader’s MT4, simply press the green ‘buy’ button if you’re going long and the red ‘sell’ button if you’re going short.

If you, as an investor, have long positions in the stock market, it means that you have bought and own shares. If you are short in this market, it means that you do not own the shares. Instead you  owe those shares to someone from whom you have borrowed in to execute your trade.

For instance, a trader who owns 100 shares of AMZN stock is long 100 shares. They have paid in full the cost of owning the shares.

A trader who has sold 100 shares of AMZN without owning those shares is short 100 shares. The trader owes those 100 shares at settlement and must fulfil the obligation to purchase the shares. Typically, the short trader borrows the shares from a brokerage firm in a margin account to make their trade.

Then, (if the short position works out) the trader buys the shares at a lower price to pay back the dealer or broker who loaned them (‘financed the margin’). If the price doesn’t fall as the trader had expected, then the short seller is subject to what we call a ‘margin call’ from their broker; they have to settle the loss.

Going long

To demonstrate going long in the currency markets let’s use the currency pair GBP/USD displayed on a one-hour time frame. On October 7th 2020 our trader goes long GBP/USD during the New York session.  He is prompted by the optimism being shown in the markets (and possibly by a full fundamental and technical analysis) that a Brexit deal will be completed with the EU before 31st December 2020. The pound responds to this optimism by strengthening against the dollar.

But overnight, the price improvement seems to have stalled. In the undulating movement of GBP/US prices, the highs are not as high as they were and the lows are lower. Our trader has awoken to a reversal in momentum and sentiment and decides to close his trade during the London session on October 8th. They believe that the bullish momentum looks to be coming to an end and it’s apparent in the media that there are fresh doubts that the Brexit negotiations will progress to a timely deal.

Going short

As an example of going short, we’ll reference the movement of USD/CHF from October 2nd to October 6th. The Doji candle* formed once the F.X. market opened and was an indication of a change in market sentiment. This market movement encouraged our trader to go short.

The lack of faith in the U.S. dollar coincided with continuing news coverage of the President’s brush with Covid 19. The broader market for shares was also bearish, and the counter-currency CHF (the Swiss franc) was regarded as a safe-haven in times of doubt.

Confidence returned as the president’s health improved, and USA equity markets also recovered. Our trader closed his short trade during the afternoon session of October 6th shortly after the USA equity markets opened. The price action/technical analysis at that point illustrated higher lows, giving credibility to our trader’s decision.

Why is long and short trading important?

Knowing how and when to take long positions and how to take short positions in the financial markets is vital. If you’ve looked at any of the forex or stock charts you’ll notice that our financial markets do not go up or down in straight lines. It is pretty difficult to buy the dips with perfect timing! But if you understand underlying trends and you know how, why and when to go long and short, you can profit when markets go up and profit when markets go down.

If you want to become a trader, then you won’t be a buy and hold investor. You have to develop the technical and fundamental skills to judge when to take long positions and when to take short positions in the market; when to buy and when to sell.

If you trade through CFD brokers, you won’t have the facility to buy and hold shares in the traditional sense. And you won’t have the facility to access the options market to use bids and puts. But, knowing how to short markets by way of spread betting or CFDs will be a valuable addition to your skillset.

When you analyse them you will see that markets range far more than they trend. This means that as a trader, you must learn when to stop your trade and re-enter the market at an opportune moment. Anyone can buy and hold shares, keep their fingers crossed and hope that the markets continually rise. But if you know how to short markets, when to stop and reverse, then your ability to capitalise on opportunities increases significantly.

Summary

We’ve looked at taking long and short positions in different markets and described the process involved. Next, we’ll look at what is meant by a spread in the context of trading.

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