“Long” and “Short” Trades Explained
*Last updated January 2019*
When we talk about trading, we often use the expressions “long” and “short” to classify two types of trades. It can be confusing to understand exactly what these terms mean, so in this article, I’m going to explain everything you ever wanted to know about what “long” and “short” trades mean. Everything you ever wanted to know about long and short trades but were afraid to ask… that’s the long and the short of it! No more jokes, I promise.
The simplest way to classify “long” and “short” trades is to say that in any trade, you are long of that from which you will profit if it rises in relative value, and short of that from which you will profit if it falls in relative value.
For example, let’s say that you buy a stock of ABC Inc. with U.S. dollars. It can now be said that you are “long” stock of ABC Inc. and “short” of U.S. dollars. This is because for you to profit, the value of the ABC Inc. stock must rise against U.S. dollars, or alternatively, the value of the U.S. dollar must fall against the stock of ABC Inc.
It should be pointed out that in a trade where you are short of a currency against some tangible asset, you would usually refer to that only as a “long” trade, and not say that you were “short” of the cash denomination. We will talk more about that later.
Another way to understand the difference between long and short trades is that if you make a trade where you want the price to rise in a chart, you are long of that instrument. If you want the price to fall in a chart, you are short of that instrument.
What, then, is a real “short” trade?
The Short Trade
From the time of the Bretton Woods Agreements shortly after the end of the Second World War until 1971, the value of the U.S. Dollar was defined as $35 per ounce of gold, and therefore effectively the “price” of the greenback was the same as the price of gold. Most major economic powers agreed to fix the value of their own currency to that of the greenback. In 1971 the U.S. began a series of devaluations of the greenback compared to the price of gold, before finally abandoning all linkage between the dollar and gold in 1976.
For this reason, there was very little Forex trading before the 1970s. Speculative traders instead focused on stocks and commodities. Traders could make money by buying stocks and commodities cheaply and selling them at a higher price. However, as traders wanted to find a way to profit when they thought that prices were about to fall, but didn’t already own any stocks or commodities to sell, the practice of going “short” arose. Traders would go short of stocks or commodities by borrowing the stocks or commodities in question, and then selling them, before buying them back later at a hopefully cheaper price. The stocks or commodities could then be returned to the loaner, and a profit taken from the difference between the original sale price and the buy-back price. It should be noted that short sellers would have to pay interest on any money borrowed initially that was required to purchase the stocks or commodities to be sold.
Therefore going short could be very different to going long. It should also be noted that stocks and commodities – but especially stocks – tend to have a “long bias”, meaning that their value is more likely to rise over time than fall. Falls in stock markets, or “bear markets” as they are often called, tend to be faster and more violent than rising markets (“bull markets”). This is arguably at least partly due to the fact that if you sell stocks that you have borrowed money to pay for, you are more likely to panic if the trade starts moving against you, than if you own stocks while the price is falling.
Long and Short Forex Trades
In Forex, things are different, because whether you are making “long” or “short” trades, you are always long of one currency and short of another. If you buy, or go long, EUR/USD for example, you are buying EUR with USD. You are long EUR and short USD. If you sell, or go short, EUR/USD, then you are long USD and short EUR. It is really all the same.
The only important factor regarding the long and short trades question in Forex is any interest you might need to pay to your Forex broker if you hold a position overnight, or alternatively receive from your broker. This is calculated by reference to the interest rates at which banks lend particular currencies to each other, at least in theory. Unfortunately, Forex brokers sometimes use this as a subtle way to make some extra money from their clients.
For example, let’s say you go long EUR/USD. You have, at least theoretically, bought EUR with USD. If the inter-bank interest rate for USD is higher than it is for EUR, your broker might be paying you some money each time you hold the position over the New York rollover time (i.e. daily). This is because you are getting interest on your USD greater than the interest they are getting on the EUR, and in theory, positions are “squared” at every New York rollover. On the other hand, if the interest rate on the currency you are long of is less than the rate for the currency you are short of, you will be charged some amount representing the difference every day that the position is kept open.
Short Stock Trades
It is worth remembering that if your broker offers trading in individual stocks, commodities, and/or stock indices, you can make short trades as well as long trades. This means you can potentially make just as much profit in a falling market as in a rising one, but when you are making short trades in stocks or commodities, be careful!