Long And Short: Definitions And Usage

Preface: In the stock market, you do not have to own something to sell it. You are allowed to carry negative positions on your books. This is called being "short" that position.

Long, Short

To be long X means you have a positive quantity of X on your books. To be short X means you have a negative quantity of X on your books. ** You become long X by buying it. You become short X by selling it. The rule to make money is, of course, to buy low and sell high. Unlike physical commodities you may actually own, there are no temporal restrictions on the order in which these take place. You can sell high FIRST, then buy low LATER.

Let's use MSFT, the exchange symbol for Microsoft.

So if you purchase MSFT stock, you would "be long MSFT stock". This is a "long position". You would make money as MSFT goes up in value or lose money as MSFT goes down in value.

If you sell MSFT stock (without owning it first), you would "be short MSFT stock. This is a "short position" in MSFT. You would make money as MSFT stock goes down in value or lose money as MSFT goes up in value.

Long and Short above are used as adjectives to describe the position you carry. They can also be used as verbs, meaning to buy and sell. This is most commonly used for selling stock to achieve a short position (selling it when you have nothing on your books, thus establishing a negative balance on your books).

Usage: "I want to short MSFT stock." You may want to do this if you think MSFT is going to sink in value over time. Then you would short (you could also say "short sell") MSFT stock at a certain price, say $25. Hopefully it would sink in value, to say $24, at which point you would buy MSFT stock. Then you would no longer carry a balance in Microsoft stock, and you will have made $1 per share you shorted.

Verb usage of Long is less frequent, but not rare. You could say, "I got long Microsoft for $25." That just means you paid $25 for MSFT. If MSFT is trading above $25, you've made money. If its trading below $25, you've lost money.

Trickiness

If you are long MSFT, then you make money as MSFT increases in value. If you are short MSFT, then you lose money as MSFT increases in value. That should be clear from above.

Now imagine there exists an Anti-Microsoft, we'll call A-MSFT. A-MSFT's stock price is equal to 100-MSFT. So if MSFT is trading for $25, A-MSFT trades for $75. If MSFT trades for $35, A-MSFT trades for $65. For every $1 MSFT goes up in value, A-MSFT goes down $1 in value, and vice versa. There exists an infallible, 100% correlation between the two stocks.

If I were to buy A-MSFT (be long it), I would make money as A-MSFT rises in value (still the same thing as above). Now consider this: by being long A-MSFT, I have a position that loses value when MSFT goes up in value. When MSFT goes down in value, my position makes money. Basically, its as if I'm short MSFT.

So yes, I'm long A-MSFT, and my position makes money as the product I'm long increases in value.

But I am synthetically short MSFT.

Synthetics

The marketplace is a pretty complicated place nowadays, with all sorts of things you can trade, much more than just plain vanilla stock. Most of these get their value by being tied, via some predetermined relationship, to a plain vanilla stock. Since they "derive" their value from other sources (called an "underlying instrument"), these other products are generally called derivatives.

Synthetics is a word that means a lot of things in the marketplace, but lets just imagine it to be a substitute of some sort.

In the above example, A-MSFT behaves with a negative correlation to MSFT. It is synthetically the opposite of MSFT. We can use this fact to determine a substitute for MSFT. So if I wanted to buy MSFT stock, I really have two options now:

1. Buy MSFT
2. Short Sell A-MSFT

The point is that I can be Long (or synthetically long) the market (MSFT) by being Short a derivative (A-MSFT). That is a confusing line for most, so hopefully if I explained it well above, it will be clear.

Basically, if I'm short A-MSFT, that means I lose money as A-MSFT goes up in value and make money as A-MSFT goes down in value. Because of the negative correlation of A-MSFT and MSFT, that means I have a position that makes money as MSFT goes up in value, and loses money as MSFT goes down in value -- just like owning (being long) MSFT.

A person might choose to use the substitute or synthetic position for a variety of reasons. Transaction costs might be lower for A-MSFT, it might be more liquid, etc.

Come back next time for a easy-to-understand lesson in basic options. A quick preview that ties this lesson to the next: Calls are synthetic LONG market positions. Puts are synthetic SHORT market positions. Therefore you should buy calls (or sell puts) when you think the market is going up. Conversely, you should buy puts (or sell calls) when you think the market might go down.

** In the stock market, you do not have to ACTUALLY own something to sell it. You are allowed to carry negative positions on your books. The way this works, technically, is that you borrow the stock from someone who does have the stock on their books, then sell it. You are required, to return the stock to the actual owner at a predetermined time. The brokerage house facilitates this, so you do not have to actually ask anyone to borrow stock.