9.2.1 Long Positions And Short Positions

Introduction

In this chapter, we explore the concepts of long positions and short positions. These terms are fundamental in understanding various trading strategies in the securities market. Developing a clear grasp of these concepts is essential for anyone pursuing certification through the Canadian Securities Course.

Long Positions and Short Positions

Long Positions

A long position represents actual ownership of a security. When an investor holds a long position, they are optimistic about the security’s future performance and profit when its price increases. Here are the key points:

• Ownership: The investor owns the security.
• Expectation: The investor expects the security’s value to rise.
• Action: The investor purchases the security and holds it in hopes of selling it for a profit later.

Example of a Long Position

An investor buys common shares of a company to initiate a long position in the stock. This means they now own those shares. The investor must pay for the stock purchase by the settlement date (typically two business days after the transaction, known as T+2). To close the long position, the investor sells the stock in the market. They would ideally do this when the stock price has appreciated, thus securing a profit.

Short Positions

A short position is created when an investor sells a security they do not actually own, expecting the price to decline. Here are the critical aspects:

• No Ownership: The investor does not own the security.
• Expectation: The investor expects the security’s value to decrease.
• Action: The investor borrows the security and sells it in the market with the intention of buying it back at a lower price.

Example of a Short Position

An investor, with permission from their dealer, sells shares they do not own to initiate a short position. The following steps are typically involved:

1. Borrowing: The investor borrows the shares they intend to sell.
2. Selling: The borrowed shares are sold on the open market.
3. Margin Account: The proceeds from the sale are kept in the investor’s margin account, and an additional margin deposit may be required if the security’s price rises.
4. Closing: The investor buys back the shares from the market to return the borrowed securities, ideally at a lower price, thereby making a profit.

Understanding Margin Accounts

For a short position, maintaining a margin account is essential. A margin account allows investors to borrow money from the broker to buy securities. The difference between the amount borrowed and the value of the securities is covered by the investor’s equity in the margin account. The maintenance of sufficient margin is crucial to guard against potential losses.

Common Questions

What are the risks of a short position?

Short selling is inherently risky because there is no upper limit to how high a stock price can rise, potentially leading to limitless losses. Additionally, investors must maintain margin requirements, which can lead to margin calls if the borrowed securities’ value increases.

How is profit calculated in long and short positions?

Profit in a long position is calculated by subtracting the purchase price from the selling price.

For short positions, profit is calculated by subtracting the repurchase price from the selling price.

Key Takeaways

• Long Position: Represents ownership of a security with the expectation that its value will rise. Profit is made by selling at a higher price than the purchase price.
• Short Position: Involves selling borrowed securities with the expectation that the value will fall. Profit is made by repurchasing at a lower price than the selling price.
• Margin Account: Required for short selling to handle the borrowed security’s sale proceeds and additional margin deposit.
• Risk Management: Short positions carry higher risk, necessitating careful risk management and margin maintenance.

Glossary

• Long Position: Actual ownership of a security with the prospective gain from rising prices.
• Short Position: Selling borrowed securities with the expectation of repurchasing at a lower price.
• Margin Account: A brokerage account that allows customers to borrow money to purchase or sell securities.
• Settlement Date: The date by which a security transaction must be finalized, typically two business days after the trade date (T+2).
• Margin Call: A demand by a broker for an investor to deposit additional money or securities to cover potential losses.

Conclusion

Understanding long and short positions in the securities market is essential for successful trading strategy formation. Through examples and discussions of margin accounts and risk management, this chapter prepares you to handle these concepts proficiently.