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Long and Short Trading Explained

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This post is also available in: Indonesia

When placing a trade, you are either buying or selling in Forex. The expressions ‘long and short’ are used to classify the types of trade you make. It might be a little confusing at first, but you will have no trouble using the terms once you understand the underlying concept. In this article, we will examine what these terms mean and how you can use them correctly.

Here’s the long and short of it (pun very much intended); the best way to understand the terms is to classify trades into long and short categories.

You are long of a financial instrument where you gain profit if it rises in value, relative to the time you make the trade. 

What is a short position? In simple terms, you are short of that from which you will get returns, if it falls in value, relative to the time you made the trade.

What is MT4 trading terminal? Read in detail here

Let’s Talk About Buy and Sell First…

If, as a trader, you open a ‘buy’ position, you are purchasing an asset from the market. When you close that position, you are essentially, ‘selling’ it back to the market. Buyers (also called bulls) believe the asset’s value will most likely go up and sellers (also called bears) think the price will fall. 

When opening a position with a broker, you are given two prices. If you want to trade using the buy price, which is usually a little above the market price, you will open a long position. If you choose to trade at the selling price, usually a little below market price, you will open a short position. The spread is usually the difference between the buy and sell prices. That is what the broker takes to facilitate the trade you want to make. After you understand the basics of buying and selling, you should have no trouble making classifications. 

Let’s Classify Long and Short Trades…

As we said, the best classification is to say that in whichever trade you make, you are long when the assets net you a profit if they rise in value and short when the assets will net you a profit from a fall in price. So, what does shorting a stock mean?

If you use US dollars to buy Apple stock, you will not be ‘long’ stock of Apple and ‘short’ on US dollars. This is so because for you to make a profit, the value of Apple stock must rise against the dollars, or the value of US dollars must fall against the Apple stock.

NOTE: In a trade where you are short of a currency against a tangible asset, you would only refer to it as a ‘long’ trade and not say that you are ‘short’ of the currency. We will get into that in a short while.

Another way to look at this for a clearer understanding of the difference in definition between long and short trades is that you are long of the financial instrument in question when you make a trade where you hope that the price will rise on the chart. If you want the price to fall, you are short of the financial instrument on the chart.

So, how do you classify a real short trade? To get a comprehensive answer on ‘what does short mean in trading?’ we have to understand something about the market’s past—time for a history lesson.

The Bretton Woods Agreement

After the end of World War 2, the world economies were in shambles. So, the west decided to create a system that could stabilize the situation. It is known as the Bretton Woods system, and in it, the agreement was to set the dollar against gold’s exchange rate.

This allowed every currency in the world to be pegged against the US dollar. The rates stabilized soon after, but not for too long. After a while, the system seemed too limiting. So, change happened. By 1971, the system was scrapped in favour of a new currency valuation system.

Compared to the price of gold, the US began devaluing the greenback and finally separated the link between gold and the dollar by 1976. The supply of gold limited the premise, which was used to implement the Bretton Woods system. The amount of gold available to back the number of dollars in circulation was not enough. With increased government spending and lending, the currency in circulation rose too high.

Because of such systems and reasons, there was not much Forex trading going on before the 70s. Speculative traders only had two options; stocks and commodities. They could make profits by buying stocks and commodities when they were cheap and selling them when the prices went up. However, the same traders also wanted to make profits when the stock value went down.

The way this worked would hinge on the fact that they did not have the stocks or commodities to sell. So, short trading arose from this. The traders would borrow the stocks and commodities that they wanted and then sold them before purchasing them back after some time at a lower price. The stocks and commodities would be returned to whoever lent them out.

The profit would be the difference between the initial sale price and the buy-back price. Short sellers would then have to pay interest on the money borrowed initially. Hopefully, that makes the answer to ‘what is trade short selling?’ easier to grasp. 

Pro-Tip

There’s something we call the ‘long bias’ in the stocks and commodities market. Unlike other asset classes, stocks and commodities tend to rise in value over time rather than to fall. A bearish trend in the stock market (when the value falls), tends to happen rapidly and violently than bullish markets (when the price rises).

The reason for this is because if you sell stocks that you have borrowed money to pay for, you will most likely panic if the trades start to move against you than if you own the stocks while the price is falling. Long-term Forex trading bears less risk because of higher volatility. 

Long and Short Position in Forex Trading

Forex Long and Short Trading

In Forex, things get a little different than in the stock market. Whether you are making long or short trades, you will always be long of one currency and short of another. If you go long (buy) the popular EUR/USD pair, you will be purchasing the EUR with USD. Therefore, you are long EUR and short USD. If you sell or go short on the same pair, you are long USD and short EUR. 

One important thing you need to keep in mind regarding Forex long and short positions is the interest you may have to pay your broker if you hold a position overnight, or what you may receive from the broker. This is calculated by using the interest rates banks use to lend each other currency (but only in theory).

Sadly, some brokers are unscrupulous and may use these charges to extract money from clients. For that reason, you need to have Forex trading explained in-depth, to avoid such pitfalls. 

Let’s Break That Cost Down

Let’s say, you go long trade on the EUR/USD pair. Theoretically, you have bought the EUR, using USD. If the USD’s interbank interest rate is higher than that of the EUR, the broker may be paying you some amount every time you hold that position over the New York rollover time.

The reason is that you are getting interest on the USD, greater than the interest on the EUR. In theory, the positions are ‘squared’ every New York rollover. If the interest rate on the currency you are long of is less than the one you are short of, you will be charged a certain amount of money every day to keep the position open overnight. 

How to Classify Short and Long Position in the Financial Markets

If you want to go long or short on the market, you have to start by opening a CFD trading account. CFD trading involves both long and short trading, to profit from the difference in a chosen asset’s price, between the opening position and when you close.

CFDs are derivative products that offer traders the chance to speculate on shares, indices, Forex, and commodities, without owning the underlying assets. With both methods, leverage is applicable, meaning you only have to put up a small margin to be exposed to the full value of the trade you get into.

As you know, leverage can magnify the profits you make or the losses, too. To be on the safe side, always consider the pros and cons of going long vs short, before you make a decision. Make a point to learn the important Forex terms to ensure that you do not get confused by definitions in concepts and jargon. 

The Effect of Buyers and Sellers on the Market

Demand and supply are usually shifted or affected by the actions of buyers and sellers. Because of their effect on demand and supply, the prices are affected. At any given time, one of the groups outweighs the other, and that is the reason why the price of a market undergoes movement to create volatility.  

When the buyers outweigh the sellers, demand rises on the market, resulting in a rise in the prices. When the situation is reversed, the supply increases and the demand drops, taking the price with it. This fluctuation of the market is what we call volatility.

A buyer’s market is when buyers outweigh sellers. They get the leverage to negotiate better buying prices for an asset because the supply exceeds the demand. A seller’s market is when the asset in question is in limited supply, and there’s an influx of buyers. The seller is then able to dictate terms.

Some Important Things You Should Know About Shorting Some Markets

As a trader, you can short most financial markets. If you are trading in futures and Forex, you can always go short if you want to. Most stocks are shortable. Some of them are not.

In 2010, the Securities Exchange Commission put in place the alternative uptick rule. The rule introduced restrictions on short selling from driving the price of stock further down, when it has dropped 10% or more, in a single day. For a trader to go short on the stock market, they have to borrow the shares from someone who owns them, using a broker. It is the whole point of CFD trading platforms.

If the broker cannot borrow the shares you want for you, you cannot short the stock. IPOs (Initial Public Offering) stocks are not shortable either.

A Summarized Process for Shorting Stock

To make all this easy to understand, let’s go through how you can short stock, step-by-step.

  1. Identify the stock you want to short.
  2. Acquire a margin account with your broker and have the permissions to open a short position on a stock.
  3. Liaise with the broker to see if you can borrow the shares needed to complete your short-selling strategy.
  4. Borrow the shares to sell them to other traders on the open market.
  5. The share price of the borrowed stock you sold short will either go up or down or stay constant.
  6. At some point, you have to close the short position by purchasing back the stock you sold initially and then return them to the lender, using your broker.

If the price went down, you would pay less to replace the shares than the price you sold them and then keep the difference as profit. If the prices went up, it would cost you more to buy them back, forcing you to fill the deficit and suffer a loss while at it.

When it comes to identifying who will lend you the shares, the work is mostly done by the broker. They are the clearinghouse that will find the customers with stock that they are willing to let you borrow for short term trading. 

You Can Make Money Either Way by Diversifying

If you can create a market-neutral portfolio, it will allow you to own stocks and sell stocks short. Buy the stocks with the best prospects and short the stocks with the worst prospects. You will make money if you are correct, whether the market falls, rises, or stays constant.

If you are wrong about a stock on which you went short, you could lose a lot of money. Theoretically, there may be no limit to how much money you could lose. Always make sure that your information is well-researched, to avoid astronomical losses that could exceed your financial weight. Understand the dynamics of long-short trading strategies before using them. 

It is wise not to start on shorting stock until you understand the markets properly as a beginner. In the meantime, focus on getting as much education as possible, so that you can make the right decisions most of the time and avoid the losses.

This post is also available in: Indonesia

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Updated  October, 2020

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