The long & short of trading

How do people make money on Ebay or any other marketplace? Simple - “buy low, sell high” - the mantra that means buying something and selling it back later for a profit. The same goes for trading. But, if you end up spending more on your trade than what you sell it for, you’ll end up with a loss.

In trading, when you own something - whether it’s stock, options, etc. - you’re “long.” If you own shares in, say, the theoretical company, Tiger, Inc., you could level up your lingo and say you’re “long Tiger.” Anything you’re long is something that you generally want to go up in value, so you can sell it for a higher price and nail that whole buy low/sell high strategy.

Risk graphs are used to visualise the potential profit or loss of a trade. If you graph out the profit and loss (you also might see this referred to as “P/L”) of a long stock position, it looks like this:

Your risk is directly proportional to the number of shares you own. If you own 10 shares of stock in our theoretical company Tiger, Inc., you will make or lose $10 for every $1 move the stock makes. Own 100 shares? Then it will be a $100 gain or loss for every $1 move of the stock. The more shares you own, the more risk you take on. It’s as simple as that.

You can also turn the buy low/sell high thing on its head and do the sell part first, then try to buy back later at a lower price. This is called “shorting”, “short-selling” or “selling short.”

Why would you short something? Well, if you think a stock’s price has peaked and could fall, shorting is a way to potentially make money as the stock goes down. (Note: Robinhood Financial does not allow you to short a stock, but it’s a strategy worth knowing about.)

To short a stock, your broker lends you someone else’s shares to sell in the market. The mechanics behind shorting options differ a bit, but the end goal is the same - you sell high first, then try to buy back cheaper (note: Robinhood Financial does not allow you to short uncovered options). Whatever it is that you sell short has to go down in value for you to profit. Otherwise, you will incur a loss.

Essentially, shorting something means you’ve sold something you don’t own, which can take new traders by surprise. When you sell something that you’re currently long, you’re not shorting. You’re just “selling to close” your trade and you don’t own that investment anymore.

Let’s come back to our example with Tiger, Inc. You seek to make money shorting Tiger, Inc. stock when the stock price drops. When you buy it back at the lower price, you’ll lock in your profit and you’re not short the stock anymore. But, you’ll lose money if the price goes higher since it’ll cost you more to buy it back than what you collected by selling it. It’s important to understand that when someone shorts a stock, they theoretically have unlimited risk of loss since there’s really no limit on how high stock prices can go.

If you graph out the P/L of shorting a stock, it looks like this:

To recap, here are some of the basic tenets of trading to keep in mind:

• When you buy something and you want it to go up in value, you’re “long” that something.
• When you “short” something, you want that something to drop in value.
• When you’re long a stock, the most you can lose is what you paid for it.If you buy the stock of a major company, it’s unlikely you’ll lose the whole thing (but it does happen). It’s also unlikely that the stock will double or triple in value in a short period. With options, however, it’s much easier to lose the entire value of your trade as an option is typically a fraction of the stock’s cost and has an expiration date (we’ll discuss this in the next article). Yet, options can also generate large gains, relative to their price. One caveat here: if you are buying stocks on margin, you can lose more than your initial investment. On the contrary, you must pay cash for long options, and cannot buy them using margin.
• When you sell something short, the most you can make is what you sold it for. Since the value of both stocks and options can only drop to zero, the amount you can profit when “shorting” is limited to the sale price i.e. 100%. However, it’s really important to note that the potential risk can be extreme in this situation, because the stock can theoretically rise forever.

Next up: A big, little primer on options

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future gains. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information purposes only and does not constitute financial advice. Any hypothetical examples are provided for illustrative purposes only. Actual results will vary.

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Options are complex products, involve significant risk and are not suitable for all investors. You could lose more than your initial invested capital. You should only invest in financial products that match your knowledge and experience. Please review Characteristics and Risks of Standardized Options prior to engaging in options trading.