To truly understand the role that stocks play in corporate finance and investing, you need to understand the terms long and short. In the context of equities trading, tend to remain a mystery for a large number of people.
After all, stocks are always the same, right? That’s actually true: Whether you’re buying long or selling short doesn’t actually change the stock itself; it just changes the nature of whether or not you’re in possession of that stock and the periods of time that you’re in possession of it.
Margin accounts allow you to buy stock without being in possession of the funds to do so. Put simply, it’s just borrowing money to buy stocks, but the mechanics are similar to short-selling.
Buy stocks long
When people think about buying stock, the majority of the time they’re thinking about buying long. Buying long means you own the stock you’re buying immediately once the transaction has taken place, and you continue to own that stock until you sell it.
People buy long with the intent of keeping the stock for at least a short period of time — perhaps for a few minutes or perhaps for as long as possible — before eventually reselling it. The exact length of time that you own the stock doesn’t impact whether the position is considered short or long.
When people buy long, they believe that the value of the stock will increase while it’s in their possession. So, they buy the stock, allow its value to appreciate, and then sell it when the value is high enough. Buy, own, sell — pretty simple, right? There’s not much more to it.
Buying long theoretically has limited loss potential but unlimited gain potential. When you buy a stock for $10, the worst thing that can happen is the company goes out of business and you lose all $10.
On the other hand, that $10 could, in theory, increase in value by an unlimited amount. Of course, reality must set in when you realize that the chances of it increasing even a moderate amount are volatile, leaving you with significant risk of loss.
In other words, the potential is there, but the reality is often far less glamorous, usually somewhere well within the range of –10 percent to +10 percent annual change.
There’s no such thing as selling long; once you sell the stock, it’s no longer yours.
Buy stocks on margin
When you purchase stock on margin, it means that you’ve borrowed money to buy stock. This usually involves opening a margin account with your stock broker, wherein the broker or an associated financial institution lends you money, usually with relatively low interest rates, in order to buy stock.
Typically, buying on margin involves maintaining a minimum balance in the account (or in a related account) as collateral in case you screw the pooch.
Investors are advised to be very, very careful when buying on margin, because stock investing tends to yield volatile and risky returns anyway, whereas the interest you’ll have to pay by borrowing on margin is a guaranteed thing. Buying on margin limits potential gains while exacerbating any potential losses because you have to pay interest on the borrowed funds.
Sell stocks short
Just like there’s no selling long, there’s also no buying short. Instead, selling short, or short-selling, means that you’re selling stocks not currently in your possession to someone else with the obligation to purchase that stock from him at a later date.
People sell short when they believe the value of the stock is going to decrease. They’re actually able to make money when the stock does poorly by short-selling. It works like this: The investor borrows X shares of a single company’s stock from a broker and sells them to someone for the revenue.
Usually this is done using a margin account, whereby the investor must maintain other assets as collateral for the loan. At some point in the future, the investor must purchase the name number of shares of stock and return them to the broker.
If the price of the stock goes down during the period that the investor shorted the stock, then when he repurchases the stock, he pays less than he earned from the sale. This scenario generates a profit.
If the value of the stock increases during the shorted period, then the investor must pay more to repurchase it than he generated in revenue from the sale, meaning he loses money. Short-selling is one method that investors use to generate income and returns even when investments are performing poorly.
Short-selling can be extremely risky. When you sell a stock and are obligated to rebuy it, the potential for financial loss is unlimited. Consider the following two examples, both of which involve a pet hamster trained to be a stock trader:
Skippy the hamster short-sells ten shares of ABC stock for $10 each. The company does very poorly and goes out of business. Because the company no longer has stock to repurchase, Skippy gets to keep all $100 from the short sale and doesn’t have to pay anyone to repurchase the stock. He uses the money to put an addition on his Habitrail home. Go Skippy!
Skippy the hamster short-sells ten shares of ABC stock for $10 each. The company does amazing and the price of the shares increases to $10 million each, leaving him owing nearly $100 million:
The difference between his initial $100 revenues (10 shares x $10 per share) and the $100 million it costs him to repurchase those shares (10 shares x $10 million per share) is $99,999,900. Skippy is found dead the next morning by the plumber unclogging the toilet. Poor Skippy!