Long and short are common concepts in the financial market. Indeed, all traders and investors have used either of the two in their careers. This article will look at the difference between going long and going short and the risks involved.
What is going long?
Going long is financial jargon for buying or being bullish about an asset like a stock, currency pair, commodity, or exchange-traded fund (ETF). Therefore, if you are long an asset, your goal is to buy it at a lower price and exit the investment or trade when its price rises.
Shopify stock price
For example, investors who went long on Shopify when it went public realized more than 5,200% gains.
What is going short?
Going short is the exact opposite of being long an asset. When you go short, your hope is that the asset’s price will decline. For example, you can place a short order if you expect a stock trading at $30 to fall to $20.
The concept of going long is relatively simple. You see a stock and you buy it. On the other hand, going short is a relatively complicated concept that involves borrowing and selling an asset.
For example, assume that you have $50,000 and that a stock is trading at $50. After doing your research, you predict that the shares will decline to $20. In this case, you will need to borrow 1,000 shares from your broker and sell them, which will leave you with $50,000.
You will buy 1,000 shares when the price drops to $20 and return borrowed stock to your broker. In this case, you will have made a profit of $30,000. Also learn about the types of orders in forex and the advantages they give you.
Long vs short: risks involved
There are risks when you go long and short on a financial asset. For example, you can buy a stock at $50 only for its price to drop to $10. Similarly, you can short a stock at $50 only for its price to double.
Indeed, we have seen many intelligent investors lose money by being long and short in the past. For example, Warren Buffett, one of the best investors, lost money when his investment in Kraft Heinz went south. He invested in the stock when it was trading at more than $80, only for it to drop to less than $30. Similarly, William Ackman lost money when his investment in Valeant Pharmaceuticals dropped from more than $250 to $10.
Short sellers have also lost money before. Ackman lost more than $1 billion when his short bet on Herbalife went upwards.
While both longs and shorts face risks, a short squeeze is the biggest risk. A short squeeze happens when an asset that has massive short interest pops. A good example of this is Tesla and Jim Chanos, one of the best-known short-sellers on Wall Street. For years, Chanos placed a large short trade on Tesla only for its stock to rise from less than $50 to more than $2,000.
Another good example of a short squeeze is what happened in 2021 when retail traders started pushing highly-shorted stocks significantly higher. Short-sellers lost billions of dollars during this squeeze. Consider the headline below.
Short squeeze illustrated
Going short is riskier than going long because a stock has no limit to how high it can go. For example, if you buy 1,000 shares of a stock trading at $10, the maximum loss you can make is $10,000.
On the other hand, if you short the same stock and it rises to $100, you will lose more money than you initially invested. This is because you will need to buy back the stock to return it to the broker.
How to create a long-short portfolio
Many successful investors have leveraged the concept of going long and short. Thus, they allocate some funds to assets they are bullish on, and they short the rest of the assets. Here is how to create a long-short portfolio.
First, ensure that you allocate most of your capital to assets that you have long positions in. For example, if you have a $100,000 portfolio, invest about 80% of it in stocks that you believe will go up. In most cases, the long portfolio will always generate positive returns. Indeed, in the past decades, the S&P 500 and other main indices have gone upwards. Allocate the rest of the funds in a short portfolio.
Second, do your research before you go long or short. Ensure that you have catalysts for your long and short assets. Some of the catalysts for your long stocks could be market share gains, margin expansion, acquisition target, and overall revenue growth.
On the other hand, some short catalysts for stocks are overvaluation, overbought stocks, accounting mistakes, fraud, and companies that misled investors. For example, shares of Nikola Motors declined sharply after a short-seller accused it of misleading investors.
Nikola share price
Third, ensure that you allocate capital wisely. We recommend that you not have too much long or short exposure to a single company.
Finally, ensure that you mitigate risk for all your positions. Below are some of the best ways to reduce this risk.
- Reduce leverage – Do not be overleveraged since you can lose more money than you own.
- Have a stop-loss – Most brokers enable you to place a stop-loss, which automatically stops loss-making investments. Use it well.
- Diversify among sectors – Having a diversified portfolio across sectors will help you reduce the risk of overexposure.
- Re-evaluating your portfolio – You should constantly evaluate your long and short portfolio to see how it is performing.
- Use options – Many long and short investors use the concept of options to lower their risks.
Going long and short are two popular concepts in investing and trading. We have looked at how the two work, why shorting is riskier, how to create a long and short portfolio, and some of the best risk management strategies to embrace.