Updated July 11, 2023
Definition of Short Position
If you are familiar with stock market dealings, you might have heard some investment analysts saying it’s an excellent strategy to take a short position for a particular stock. Taking a short position (SP) in stock market terms means selling a specific stock that the investor doesn’t own to make profits from the expected price drop by buying the said stock at such a dropped price.
How Does it Work?
Investors can take two types of positions in the stock market: the long post and the SP. When an investor takes a long position, they buy the stocks and take ownership. The investors’ expectations while taking a long post for any stock is that the stock prices shall rise in the future, and the investors would be in a position to sell the stock at such a future date at a higher price and earn profits.
On the other hand, when the investors expect that the stock prices will decrease in the future, they do the opposite, i.e., they take SP. It means that even before acquiring the stock ownership, they sell it to some other investor and owe them those shares. The investors then buy these stock units when the prices of the stock fall in the future. In some jurisdictions, investors cannot sell the units without owning them. In such cases, investors must borrow the securities from a stock loan department before taking a short position, and interest must be paid on such borrowing as long as the temporary position continues.
Example of Short Position
Let us suppose that the stock of an automobile company is selling at $10. An investor expects that due to the increase in the tax rate on cars, the sale of cars will decrease, and the stock of the automobile company expect to fall. The investor can take SP and sell the company’s stocks without owning them. When the prices fall in the future, the investor can buy the stocks at a lower price and close the SP to earn profits.
In this example, if the stock price moves to $8 after one month, the investor would have earned $2 per unit by closing the SP. This is because the investor initially sold the store for $10 and bought the same stock after one month at $8, resulting in a gain of $2 per stock unit.
Need for Short Position
You might wonder why anyone would sell the stocks without having owned them. The reason for doing so is that taking an SP is an investment strategy based on speculation of a decline in stock prices. There can be two primary purposes for adopting this investment strategy:
- Earning Speculation Gains: Investors with rich experience and knowledge of stock market operations adopt this strategy for earning gains out of speculations of declining stock prices. However, one must have good market knowledge to adopt a theoretical approach, or losses can be huge.
- For Hedging: Sometimes, the purpose of taking SP in any stock or any other asset is to hedge against the risk that might be there due to holding a long position for the same stock or asset. Taking a short position in the same stock or asset can offset any downside risk of the long post.
How Long to Hold a Short Position?
There can be no specified period when it comes to holding an SPThe investor can continue to maintain a short position as long as they take care of the following things.
- The investor shall be able to meet the margin requirements as the broker may have laid out.
- The investor shall continue to pay interest on the stock units borrowed, and the lender of the units shall continue to lend the stock units to the investor.
The investor can close the SP as soon as they achieve favorable prices.
Other Short Positions
There are two main types of SPs: the naked short and the covered short position.
- Naked short position: A SP is said to be a naked short position when investors take a short position without possessing the stocks. However, such short posts are prohibited in some countries, the USA being one such country.
- Covered short position: Contrary to the naked short position, a naked short position is the one in which the investor is taking such a position possesses them. In such cases, the stocks are first borrowed from a stock lending agency and then sold to another party. The investor needs to pay interest on the stock units borrowed as long as the borrowing continues.
Conclusion
Taking a short position is a kind of investment strategy that only experienced stock market players should take. One needs good market knowledge to risk taking SP, or the losses can be severe. Investors anticipating profits by speculating on declining stock prices use the SP strategy.
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