In trading, you can open either a long or short position depending on your expectations of market price movements. This post provides a comprehensive understanding of both positions, covering:

• Preliminaries: Fundamental concepts such as position, open position, and closed position.

• Long Position: Taking a long position involves buying an asset with the expectation of profiting from a rising market by selling the asset at a higher price.

• Short Position: A short position involves borrowing an asset from a broker, selling it on the market, and later buying it back to return to the broker, aiming to profit from the difference between the selling and buying prices.

• Pros and Cons of Short Positions: Short positions allows traders to profit from a falling market and serves as a hedge. However, they could incur unlimited losses while the maximum loss of long positions is the initial investment.

Preliminaries

Before diving into the concepts of long and short position, it’s important to cover three more fundamental concepts: position, open position, closed position.

Position

A position refers to the amount of an asset that an investor holds or trades. It is defined by size (quantity of the asset) and direction (whether the investor is buying or selling). There are two main types of positions: long and short. 

• Long position: Involves buying an asset with the expectation that the asset’s price will rise.

• Short position: Involves selling an asset with the expectation that the asset’s price will fall.

We will detail these two types of positions later.

Open position

An open position is an entered trade that has not yet been closed with an opposing trade. For example, an investor who buys 1 lot of gold is said to have an open position in the gold trading market. An open position is still able to generate a profit or incur a loss, depending on the price movement. When a position is close, all profits and losses are realized, and the trade is no longer active.

Open positions offer the opportunity to gain returns. Without an open position in a market, an investor would have no exposure and so couldn’t expect to receive any return. However, exposure comes with the risk of losing money. Your position is open to the risk until it is closed. 

Closed Position

Closing a position refers to the act of exiting an open position by executing an opposite trade. For example:

• If you’ve opened a long position on an asset, closing the position means selling the same asset. 

• If you’ve opened a short position on an asset, closing it means buying back the same asset. 

Closing a position finalizes the trade, locks in profits and losses, and updates your trading account balance accordingly.

The following are situations where you need to close a position:

• Locking in Profits: To realize profits from a position you’ve opened, you must close the position. Otherwise, you just simply observe the value of your position increase without receiving cash.

• Limiting Losses: To prevent further losses, you might close a position if the asset’s price moves against the position.

• Market Insight: New information or analysis might suggest that the price trend is reverse, prompting you to close your position.

• Risk Management: Closing positions can help rebalance a portfolio, reducing market exposure.

Long vs. Short Positions

With the above concepts in mind, we now explore the definition of  long and short positions, as well as the differences between them.

Long position

Taking a long position (also, “going long”, “long buying”)  in an asset means buying that asset with the expectation that its price will rise in the future. If the asset’s price increases, you can profit by selling it at a higher price than what you initially paid. Let’s break it down with an example:

• Going Long: You take a long position on one lot (100 troy ounces) of gold at $2,480.00, expecting the gold price will increase.

• Price Rises and Position Closed: The gold price rises to $2,480.50 and you decide to lock in profit at this new price.

• Profit Calculation: Your profit of this long position is $50, calculated as (entry price - exit price) × lot size: ($2,480.50 - $2,480.00) × 100 = $50. The entry price is the one at which you open this position, while exit price is the one at which you close the same position. 

This calculation shows the basic profit or loss. Keep in mind that the actual profit is also influenced by factors like transaction costs, bid-ask spreads, and margin requirements. These costs are not included in this calculation to keep the example straightforward. The same approach applies to the following calculations.

Note that you could lose if your anticipation fails and the price keeps going downward. The maximum loss is your initial investment – the money you pay to open this long position

Short position

Taking a short position (also, “going short”, “short selling”) in an asset means selling the asset you don’t own with the expectation that its price will decline in the future. The mechanism of profiting from a short position is a bit more complicated. For instance, in a traditional gold trading market, going short involves selling a borrowed asset that you don’t own in the hope that its price will go down, and you can buy it back later for a profit. Let’s illustrate with an example:

1. Going short: You believe that the gold price is more likely to drop and so you go short on 1 lot of gold at $2,480.50.

2. Borrowing: When you go short, you borrow 1 lot of gold from your broker, and then sell it at $2,480.50.

3. Price Drops and Position Closed: The gold price drops to $2,480.00 and you decide to close your short position at this new price. What is happening is that you are able to pay less to buy back the same amount of gold, and then to return the gold to your broker.

4. Profit Calculation: Your profit is $50, calculated as (entry price - exit price) × lot size: ($2,480.50 - $2,480.00) × 100 = $50.

Conversely, if the price keeps increasing which goes against your short position, you will lose. The loss could be theoretically unlimited.

Summary

You can open either a long or short position on an asset, depending on your expectation of its price movement. An open position exposes you to the market, creating the potential for gains. However, profits are only realized when the position is closed. Closing a position is executing the opposite trade. The profits are derived from the price difference between opening and closing of the position.

Risk of Short Position: Unlimited Losses

Selling short can be costly if the seller bets wrong about the price movement. This is because losses can be theoretically unlimited. Unlike a long position where your maximum loss is limited to your initial investment (100% of what you paid for the asset), a short position has no upper limit to potential losses if the asset’s price continues to rise. This is because you still have to buy back the asset, regardless of how high the price goes. The losses are determined by the difference between your entry and exit price. The exit price varies, depending on the market movement and your decision on when to exit.

For example, if you sell one lot of gold at $2,480.00 and unfortunately the price keeps moving against you, the loss depends on your exit price which could be theoretically infinitely high. Here is a reference table to show how the loss on a short position could be unlimited:

Benefits of Short Selling

Despite its risks, short selling offers several advantages:

• Profit Opportunities in Declining Markets: Short selling allows you to profit from falling prices, giving you opportunities beyond traditional long-only strategies.

• Hedging: Short positions can serve as a hedge against long positions or other investments. If the market declines, gains from your short positions can offset losses elsewhere, providing a buffer against risk.

Conclusion

Understanding the concepts of long and short positions, as well as the associated risks and opportunities, is essential for making informed trading decisions. While long positions offer the potential to profit from rising markets, short positions provide opportunities in declining markets. However, both strategies carry inherent risks, particularly short selling, which can expose traders to unlimited losses. By managing open and closed short (long) positions carefully, you can better navigate the complexities of the financial markets. MC Prime provides a free demo account for you to practice short selling and long buying with no risk of losing real money. Sign up today and start practicing.