The Long and Short of Trading Stocks

Investors have two main ways to make money when stocks move, though many investors have heard of only one. Everyone knows you can profit on stocks as they go up, but you can also make money as they fall.

Here’s a bit more about each strategy.

Buying a stock, or ‘going long’

When you buy a security — a stock, a bond, an option, anything — the professionals say you’re “going long” that asset. It reflects the adage “buy low and sell high.” So you could go long Microsoft or Coca-Cola, or whichever company your research has led you to, and as the company’s sales and profits rise over time, its stock price should go up.

The upside to buying stock: There’s no limit to the upside when you go long. A $50 stock can double to $100, move to $150 and keep rising indefinitely. The best stocks continue to compound their gains over time — look at Amazon, which has risen 49,000% since its initial public offering in 1997 — and many investors hold their positions for decades. Of course, plenty of stocks don’t achieve these kinds of gains.

The downside to buying stock: Shares could fall to zero and you’d lose your entire investment. (You’re not locked into a position, though; if you see the stock falling, you can always look to sell.)

Getting started buying stocks is relatively quick and easy. You don’t need a lot of special permissions or a margin account that would let you borrow money to buy stocks, and many brokerages don’t have account minimums for long-only investors, as they do for short-sellers. All in all, buying stocks — or going long — is much simpler than short-selling them.

Short-selling a stock, or ‘going short’

Less well-known is that you can profit when stocks go down by selling stocks that you don’t own. That sounds unbelievable, but it’s called short-selling, or “going short” a stock. It flips that adage to “sell high and buy low.”

To short a stock is to wager that its price will tumble, perhaps due to the company’s declining sales and profits, and that you can buy it later at a lower price.

You borrow stock from a broker, sell it in the market and then buy it back later to close your position. You get cash from the stock sale, which is effectively a margin loan from the brokerage, and should the stock price indeed go down, you buy up the stock, return it to the lender and pocket the difference.

That sounds simple enough, but short-sellers need to do a few other things that long-only investors don’t have to:

  • Short sellers need a margin account, since they’re borrowing from the brokerage and paying interest on the outstanding debt.
  • To make the trade, short-sellers need cash or stock equity in that margin account as collateral for the short position, equivalent to at least 50% of the short position’s value, according to Federal Reserve requirements. In addition, short-sellers cannot spend the cash they receive from the short sale.
  • To maintain the short position, the investor must keep sufficient equity in the account as collateral for the margin loan, at least 25% per exchange rules. However, brokerages may have a higher minimum, depending on the riskiness of the stocks as well as the total value of the investor’s positions.
  • If the stock pays a dividend while shorted, the short-seller must repay that to the owner from whom the stock was borrowed.
  • Finally, short-sellers may also have to pay a “cost of borrow,” or a stock loan fee paid to the brokerage, some of which often goes to the actual owner of the stock as an inducement to lend it. This fee might be a few percent annually of the total stock value, though for stocks that are popular shorts and in difficult market times, it may go much higher.

Because of these complexities, most investors stick to going long and leave shorting to the professionals.

Each element reduces the potential profitability of a short position. Given the market’s long-term upward bias — and the fact that hope springs eternal — many investors find it hard to short stocks and achieve consistent, profitable results.

There’s a maximum gain when shorting a stock, the total value of the shorted stock. Shorting 100 shares of a $50 stock caps your gain at $5,000, assuming the stock goes to $0. Shorting does not allow you to compound your gains, as going long does, but as the stock declines you need to maintain less equity in your account to hold the position.

You can lose more than you initially borrowed from the broker. In fact, theoretically there’s no limit to how much you could lose. A $50 stock might rally to $100 and then $200. If the stock does rise, a short-seller might receive a “margin call” and have to put up more collateral in the account to maintain the position or be forced to close it by buying back the stock.

For those who still would like to profit on a stock’s decline, put options may be a more attractive trade.

Controversies around shorting stocks

Short-sellers receive all kinds of criticism. Some investors claim short-sellers are hurting their businesses or are manipulating opinion by saying something bad about the company or stock. Some say that short-sellers merely spread lies, while others imply that short-sellers are almost unpatriotic for not supporting publicly traded companies.

But short-sellers often bring new information to light, leading the market to a more sober assessment of a company’s prospects. That can have the effect of keeping a stock at a lower price than it would have if only cheerleaders were on the sideline. The shorts help keep unbridled enthusiasm in check, and often they uncover fraud, aggressive accounting, or just poorly run companies,  information that may well be hiding in a company’s filings with the Securities and Exchange Commission. These are all valuable functions in the capital markets.

Still, there’s nothing holy about longs or shorts, and both play a role in creating an efficient market that keeps trading costs lower for everyone.

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James F. Royal, Ph.D., is a staff writer at NerdWallet, a personal finance website. Email: Twitter: @JimRoyalPhD

The article The Long and Short of Trading Stocks originally appeared on NerdWallet.