Business, Legal & Accounting Glossary
In the English language, the word “short” is sometimes used to indicate an inadequacy, as in “short of cash” or “short of time.” In finance, this usage is applied to situations where a party sells securities he does not possess. Such a sale is called a short sale because it creates for that party an inadequacy—a net negative position—in the sold security. Short selling—or shorting—is perfectly legal in most jurisdictions. You simply borrow the securities from one party and sell them to another party. Short selling is one of the primary reasons for securities lending, without which, short selling would be impossible.
A party who sells securities short is called a short seller or simply a short. Often short-sellers are speculators who anticipate that a security’s price will decline.
Consider an example. A speculator borrows 10,000 shares of IBM stock when the stock is trading at USD 100. She sells the shares at that price. A month later, the price of IBM has fallen to USD 95. She buys 10,000 shares at that price and returns them to the party from whom she borrowed the original 10,000. Ignoring transaction costs and payments to the lending party, she pockets USD 5 per share—or USD 50,000 for the entire transaction.
A portfolio that has a net negative holding in a security is said be short that security. If it has a net positive holding in the security, it is said to be long the security. Such holdings are referred to, respectively, as a short position and a long position in the security A long position benefits from an increase in the security’s price. A short position benefits from a decline in the security’s price.
One might think that, if short-sellers were aggressively shorting a particular security, that this would portend a decline in the security’s price. Paradoxically, the opposite is often true. Because shorts must eventually buy back those securities they have sold short, they represent pent up demand for the security.
A short squeeze is a speculative trading strategy that is sometimes observed when a security has been heavily sold short. Recognizing the situation, speculators start acquiring the security, driving up its price. As the price rises, short-sellers have to post additional collateral for their borrowed securities. This puts pressure on the shorts. Some won’t have sufficient collateral to post. Others will simply decide they don’t want to hold a position that is losing money. Either way, those shorts close out their positions—buying the securities in the market and returning them to the parties who lent them. By purchasing the securities, these quitting shorts drive the price higher, putting more pressure on the remaining shorts.
In a short squeeze, the price of the shorted security can rise above levels that anyone might otherwise consider reasonable. The squeeze becomes a battle of wills between the shorts and the speculators who are squeezing them. If the squeeze succeeds, the shorts will be forced to buy the security at unreasonably high levels. The speculators who forced them to do so will sell at those elevated prices and pocket a profit. If the squeeze fails, the price of the security will fall. The speculators will suffer losses on their long positions and the shorts will profit—or at least not lose their shirts.
A long-short position combines a long position in one security and a short position in another. For example, a speculator may not have a view on whether the stock market overall will appreciate or depreciate in the near future, but suppose she believes that technology stocks will outperform oil stocks. To act on this view, she might create a long-short position by acquiring a technology stock she likes and selling short an oil stock she doesn’t like. If the long and short positions are for equal numbers of shares, the long-short position exposes the speculator to the spread between the price of the long stock and that of the short stock. More often, she will match them dollar for dollar instead of share for share. This will expose her to the difference in their respective returns.
A portfolio is said to be market neutral if all its short positions offset all its long positions, leaving the portfolio with no net exposure to the overall market. In essence, the entire portfolio is a long-short position in multiple securities. Its performance is unaffected by broad market movements. Instead, it depends upon relative movements in the prices of the long and short securities. In equity markets, a market-neutral portfolio is structured to have a zero net beta.
While the “long” vs. “short” terminology first developed in securities markets, its meaning has evolved to encompass similar contexts in the commodity, energy and derivatives markets. Generally, if the market value of a portfolio increases or decreases with the price of some asset, the portfolio is said to be long that asset. In the opposite case, it is short the asset.
If a portfolio has sold natural gas forward, it is said to be short natural gas. Note that no actual short sale of natural gas has taken place—the portfolio has not borrowed natural gas for the purpose of selling it. However, a similar effect was achieved by selling the natural gas forward. Accordingly, “long” and “short” refer more to net exposure than to the actual mechanics of how that exposure was achieved. In this sense, a portfolio is long an underlier if its delta for that underlier is positive. It is short the underlier if the delta is negative. You can go long an underlier by buying calls on the underlier. You can go short by buying puts.
Consistent with this convention, in some derivatives markets, it is common to speak of one party as being long a derivative and the other party being short the derivative. The long party is the one for whom the derivative creates a long exposure in the underlier. For example, with a futures contract on aluminium, the party who will receive aluminium under the future is said to be long the future. The party who will deliver the aluminium is said to be short the future. In some derivatives markets, this convention is ambiguous. What is the underlier of a fixed-for-floating swap? In the swap market, there is a convention that the receive-fixed party is long the swap. However, you are likely to avoid much confusion if you speak of the receive fixed and receive floating parties instead of the long and short parties to a swap.
Even more generally, the terms “long” and “short” are used to describe exposure to almost any financial variable. For example, you can be long or short a given spread. A negative vega position may be described as short volatility, etc.
Borrowing a security (or commodity futures contract) from a broker and selling it, with the understanding that it must later be bought back (hopefully at a lower price) and returned to the broker.
Recommended reading: The Pros and Cons of Short Selling Stocks by InvestorGuide.com
Short selling (or “selling short”) is a technique used by investors who try to profit from the falling price of a stock.
For example, consider an investor who wants to sell short 100 shares of a company, believing it is overpriced and will fall.
The investor’s broker will borrow the shares from someone who owns them with the promise that the investor will return them later. The investor immediately sells the borrowed shares at the current market price.
If the price of the shares drops, he/she “covers the short position” by buying back the shares, and his/her broker returns them to the lender. The profit is the difference between the price at which the stock was sold and the cost to buy it back, minus commissions and expenses for borrowing the stock.
But if the price of the shares increases, the potential losses are unlimited. The company’s shares may go up and up, but at some point, the investor has to replace the 100 shares he/she sold. In that case, the losses can mount without limit until the short position is covered.
For this reason, short selling is a very risky technique. For a while, SEC rules only allowed investors to sell short only on an uptick or a zero-plus tick, to prevent “pool operators” from driving down a stock price through heavy short-selling, then buying the shares for a large profit. This rule was eliminated in July 2007.
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This glossary post was last updated: 21st November, 2021 | 0 Views.