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Short Position

Short PositionA short position, also known as the bearish position, is a type of financial instrument that is contrasted with a long (bullish) position.

What Is a Short Position?

It is the position created during the sale of securities, commodities or currencies that the merchant does not own at the time of sale. Such an operation (short selling) is possible if the contract terms ensure its execution after some time or during margin trading. In the case of margin trading, it is allowed to sell the goods borrowed from the broker with the intended subsequent purchase of the same product and return the loan in the form of shares.

The short seller hopes that the price will fall and they will be able to buy the previously sold goods at a lower price. This mechanism gives them an opportunity to make a profit at lower prices. Speculators may go short hoping to get a profit on an asset that appears overvalued. Traders or fund managers may hedge a long position through one or several short positions.

Short positions are typically related to currency markets, futures, options, or public securities due to the liquidity of those assets. To open a short position, a trader must have a margin account and pay interest on the value of the borrowed shares during the time the position is open. To close - a trader buys the shares back on the market and returns them to the broker.

Types of Short Positions

There are two types of short positions: naked and covered.

  • A naked - is when a trader sells a security without owning it. However, that practice is illegal in the U.S. for equities.

  • A covered - is when a trader borrows the shares from a stock loan department. In return, they pay a borrowing rate while the short position is open.

Short Selling Metrics

To track the short selling activity on a stock, the following metrics are used:

  • Short interest ratio (SIR), also known as the short float - the ratio of shares that are currently shorted in comparison with the number of shares available in the market. A very high indicator is associated with falling or overvalued stocks.

  • The short interest to volume ratio (days to cover ratio) - the total shares held short divided by the average trading volume of the stock per day.

If a stock is actively shorted with a high SIR and SIVR, it is also at risk of a short squeeze, which happens when a stock begins to rise and short sellers start buying back their SPs. Demand for the shares attracts more buyers, thus pushing the stock higher and causing even more short sellers to buy back their positions.

Short Currency Contracts

Opening SPs on the foreign exchange markets is different from short selling on the stock markets. Currencies are traded in pairs, where the price of one currency impacts the price of another one. Therefore, a currency contract is always short in terms of one medium and long in terms of another. When the exchange rate changes, the trader buys the first currency again and returns the loan. Since they got more money than they have initially borrowed, they make a profit, and vice versa.

Let's suppose that a trader wants to trade with the USD and JPY currencies. Assume that the current market rate is USD 1 to JPY 108 and the trader borrows JPY 216 to buy USD 2. If the next day, the conversion rate becomes USD 1 to JPY 109, then the trader sells their USD 2 and gets JPY 118. After that, they return JPY 216 and keeps the JPY 2 profit minus commission.

Short Futures and Options Contracts

When trading futures contracts, going short means having the legal obligation to deliver something at the expiration date of the contract. At the same time, the SP holder may buy back the contract before the expiration date instead of delivering the product.

Short futures contracts are typically used by:

  • Producers of commodities such as oil or grain to fix the future price of goods that they have not yet produced.

  • Long position holders who short sell a futures contract as a temporary hedge against the price drops.

  • Speculators looking to profit from any decline in the price of the futures contract before it expires.

An investor can also purchase a put option, getting the right (not the obligation) to sell the underlying entity at a fixed price. In the case of a market decline, the option holder may use these put options. As a result, another party has the obligation to buy the underlying entity at the agreed "strike" price, which would exceed the current quoted "spot" price of the asset.

Short Selling Strategies

Short sellers can use the following strategies:

  • Arbitrage - benefiting from market inefficiencies resulting from the mispricing of specific products.

  • Hedging - minimizing the risk from a more complex set of transactions. For example, a farmer who has just planted their wheat wants to lock in the price at which they can sell after the harvest and thus take a short position in wheat futures.

  • Selling against the box - holding a long position on which the shares have already risen and entered a short sell order for an equal number of shares after that.

Short Selling Criticism and Advantages

Because of the practices used by unethical speculators, short selling earned a bad reputation. The actions of those speculators result in artificial deflation of prices and "bear raids" on vulnerable stocks. Though such operations are illegal in the U.S., they can still happen.

SS has been criticized since the 17th - 18th centuries when it first appeared. For example, short sellers were blamed for the collapse of the London banking house of Neal, James, Fordyce, and Down in 1772, which led to a major financial crisis. The bank had been speculating by massively shorting East India Company stock and apparently using customer deposits to cover the losses. Short sellers were also blamed for the Wall Street Crash of 1929.

During that time, the stock exchange speculation led to heavy investments in the stock market, which created an economic bubble. People were borrowing money to buy more stocks, and the amount of this borrowed money exceeded the total amount of currency that was circulating in the USA. This caused a sharp decline in prices. However, despite the criticism, SS brings liquidity to markets and can help prevent bad stocks from rising. Short selling activity is a legitimate source of information about market sentiment and demand for a stock. This information helps the investors to stay up to date with the latest trends and thus avoid any unpleasant surprises.

Summary

A short position is created during the sale of assets that the merchant does not own at the time of sale. SPs are typically related to currencies, futures and options, and publicly traded securities. When going short on the forex markets, traders typically combine the long selling with short selling because of the currency pairs with different pricing involved. Futures contracts are typically used by producers of commodities who hope to fix the future price of goods that they have not yet produced. They are also used by long position holders to hedge against price fluctuations as well as by speculators hoping to benefit from the future price declines.