What is a short position?
Looking for a short position definition? This is an investment or trading technique commonly used when an investor believes the value of a stock is about to drop. First, the investor borrows stock from a broker and then sells it on the market. Later on, they buy the stock back and return it to the broker. If the price of the stock has dropped, the investor makes a profit.
Short positions can be adopted with other types of asset too – for example, exchange-traded funds, currencies and commodities. Hedging and speculation are the two main areas in which short positions are applied. A short position is the opposite of a long position.
Where have you heard about short positions?
The 2015 movie The Big Short made this investment strategy more mainstream. The Oscar-winning film featured a handful of traders who saw the 2007-8 financial crisis coming and took a short position against home loan-backed securities. When the crisis did finally happen, these traders made a lot of money.
Shorting a stock still isn’t a very common investment strategy though, and is usually only practised by professional investors, typically hedge fund managers. Some investors will take a short position whenever they feel an asset is overpriced in relation to its underlying value.
What you need to know about short positions...
Investors can borrow stock from brokers by paying interest as a fee. This is how shorting a stockworks:
- The investor borrows a stock whose price is likely to decrease from a broker, and agrees to return it at a later date.
- The investor sells the stock on the open market.
- The investor then buys back the stock once its price has dropped below the price they originally sold it for, and returns it to the broker.
- The more the price of the security has declined from the time it’s sold, the more profit the investor makes.
Alternatively, investors can go short using contracts for difference (CFDs) which involves no borrowing and is a pure trade on the price difference.
Short trades come with unlimited risk and limited reward. For example, if an investor sells borrowed stock at £10 a share, the maximum they could make is £10 minus any fees – that’s if the stock hits zero. If the stock goes above £10, the investor will make a loss when they buy back the stock and return it to the broker.
What’s the difference between short and long positions?
When you’re trading assets, you can take one of two positions – short or long. As we’ve already discussed, if you think an asset’s value will go down, you can take a short position. A short trade is initiated by selling first.
If you think an asset’s value will go up, you take a long position, which is the most conventional way of trading. A long trade is initiated by buying. You make a profit if you sell for a higher price than you paid.
An investor who takes a short position has a bearish view of the market, while someone who takes a long position is said to be bullish.
For investors going long, the main risk involved is a fall in the value of the asset they own, resulting in a loss. The main threat for those shorting a stock is a rise in the value of the shares they’ve borrowed. The investor must still repay the borrowed funds even if they didn’t make any profit.
Short trades are considered risker than long trades. With long positions, losses are limited because they can’t fall below zero, but with shorts the risk is infinite because there’s no upper limit to share prices. To mitigate this risk, stop-loss orders are sometimes employed by investors to put a threshold on how much they can lose.
Short positions in futures
While short selling is usually done with stocks, it can be applied to most financial markets. In the futures market, a business supplier will often lock in the price of a commodity they’re going to sell at a future date.
When agreeing the terms of a futures contract, the party taking the short position agrees to deliver a commodity, while the party that agrees to receive the commodity is taking a long position.
For example, suppose a wheat producer wants to lock in a selling price for next season's crop, while a bread-making firm wants to hedge against volatility in the commodities market by agreeing a set price to buy wheat. The farmer and bread-maker may enter into a futures contract requiring the delivery of 5,000 bushels of grain to the buyer in three months’ time at a price agreed today of £4 a bushel. If the price falls below £4, the seller benefits, but if the price rises, the buyer benefits.
Speculators and hedgers will also buy and sell futures to make a profit. They’ll sell futures (a short position) when they think prices will fall, or buy futures (a long position) when they think prices will rise.
Where options trading is concerned, short is simply the selling of an options contract.
When a trader shorts a call option, they give the buyer the right to buy the underlying stock at the strike price at any time before the expiry date and benefit from the premium received if the price of the underlying stock goes down instead of up.
When they short a put option, they give the buyer the right to sell the underlying stock at the strike price at any time before expiration and benefit from the premium received if the price of the underlying stock goes up.
You can use short calls to boost the return from your portfolio, although you don’t always profit. For example, if you hold 10,000 shares in a company currently trading at 565p each, you might decide you’d be happy to sell them if they advanced to 600p.
Instead of just waiting for the shares to achieve this price, you could short a call against your stock with a strike price of 600p. That means you agree to sell your shares into the market at a price of 600p if they reach or go above that level at expiry. In return, you take a certain amount of option premium.
If you’re researching a company whose stock you’re interested in buying, you might come to the conclusion that the stock will head lower rather than higher after reviewing the business's market position, future prospects and current valuation.
Many people will simply move on if things aren’t looking bullish, continuing their search for a different stock that has the potential to beat the market. However, opportunistic traders with bearish sentiments and a strong risk tolerance may decide that initiating a short position is the smarter way to go.
Many seasoned investors carry several different types of position at any one time in addition to diversifying the range of investments held in their portfolio to minimise the overall risk. Shorting a stockis just another string you can add to your bow.
Find out more about short positions…
Read this article on why economists don’t believe short selling was to blame for the 2008 financial crisis.