Going Long vs Short
The stock market is very interesting because where one trader sees an opportunity and the other trader sees a caution sign. Only the future will tell who is right and who is wrong. In this post, I would throw a light on how traders make money by holding stocks for a short/long time.
Usually, to make a profit in the stock market, one would buy stocks at a cheap price and sell them at a higher price. Some people don’t trade daily. They would buy stocks that they like, plus hope that they would grow over time. On the bright side, there is a tax advantage for going long. For example, If you sell a stock after a year, you would pay lesser tax on the profit than if you would have sold it under a year.
What if you know that certain stocks will go down in value? Can you make a profit on your belief?
The answer is yes. Look at the diagram below:
Your immediate question would be “how would I sell something that I don’t own”. The answer is ….. you borrow stocks from someone who already owns them. The person is willing to lend you stocks because this person thinks that stock would do good in the long term and by lending you stocks, they make a little extra.
How do you short stocks?
Your broker/app that you are using to trade would provide you the stocks that you want to short. You pay your broker/app money for lending the stocks. You sell it (let’s say at $200). When prices go down (at $100), you buy stocks and give them back to your broker.
Sequence of events:
- You paid fees to borrow stocks (let’s say $20)
- You sold stocks at $200
- You bought them back at $100
You just made ($200 sell price — $100 stock price -$20 borrow price = $80/stock)
It seems really great because you just put in $20 and you came out with $80 in profit. However, the risk of shorting stocks can be substantial.
What if the stock goes in the other direction? What if instead of going to $100, the stock shot up to $300?
When you borrow something, you have to return it within certain time. As price has already reached $300, it might even go higher to $400. If you decide to clear your debt you would buy stocks at $300. So the sequence would look like following:
- pay fees to borrow stocks ($20)
- sell stocks at $200
- buy stocks at $300 & return them to lender
Your profit = $200 (sell price) — $300 ( buy price ) — $20 ( borrow price)= -80/share
With the above trade, you would lose $80.
But let’s say if you want to wait a little more before clearing your debt, you would have to pay money to keep borrowing stock.
In either case, you are only paying $20/stock upfront. Brokers keep an eye on your portfolio. They would only let you take short positions if they think you can clear the debt. Brokers also have the rights to recover money by liquidating your portfolio. Brokers are taking calculated risks on their side. You should also take calculated risks. By shorting stocks, you are taking a substantial risk. There is a way to minimize risk (but might pay more upfront) by trading on options that I would cover soon. Until then happy trading :).