Long & Short Trading Explained

Adam Lemon

When we talk about trading, we often use the expressions “long” and “short” to classify two types of trades. I explain what this means below. 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” trading means. 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 Difference Between Long and Short Trades

The simplest way to explain “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.

Long vs Short Position

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.

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. I 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 commodities and stocks cheaply then 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, 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. Short sellers would have to pay interest on any money borrowed initially that was needed 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 –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 happen more quickly and violently than rising markets (“bull markets”). This is probably at least partly because 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 Trading Explained

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: there are no true “long” or “short” trades in Forex.

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 currencies to each other, at least in theory. Unfortunately, Forex brokers can use this as a way to make some extra money from their clients, by charging overnight Forex swaps on both long and short sides of the same trade.

For example, let’s say you go long EUR/USD. You have 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.

Especially in stocks, there is a real difference between long and short. This is because stock markets have a long bias, meaning over any given period they have a statistical tendency to rise. Identifying periods of prolonged and continuing falls in the levels of major stock indices is very hard and perhaps even impossible to perform with technical analysis.

The major stock index is the S&P 500, which is an index composed of the 500 major U.S. stocks. It has been in existence since 1957 but it is possible to calculate its values for some years before then. Let’s look at how this index has performed historically.

S&P 500 Index: Long Bias Demonstration

Imagine that we just bought the Index every week from 1950 until April 2021, which is a lengthy period. This would have produced an average weekly result of 0.18%. This is a great result and shows just how resilient the American stock market has been over the past 65 years overall. It is a clear demonstration of the index’s long bias, suggesting that when you are going short, all other things being equal you have the odds against you. Of course, we really need to apply a trend-following model to try and get a better idea of the Index’s behaviour. Also, we will probably get more relevant results if we restrict any back testing to something close to the last 20 years.

So, if we look at the S&P 500 Index since 1997, let’s say we buy only at weekly opens where the price is higher than it was both 3 and 6 months ago, and sell when the opposite is the case. This kind of trend-following strategy tends to produce positive results with USD denominated Forex pairs and with many commodities.

However, when applied to the S&P 500, this strategy can produce positive results on the long side, but only losing results on the short side:

Long weeks: 531 trades, average weekly performance =+0.09%

Short weeks: 227 trades, average weekly performance = -0.06%

No matter which lookback periods we use to filter the signals, ANY period that we use on the short side produces an average negative result, while almost any period we might apply to the long side achieves a positive result.

Which Stock Markets Have a Long Bias?

The first question you might ask yourself at this point is whether all stock indices are like this? We should divide this question into geography and sector. For example, if we look at the NASDAQ 100 Index, these are still composed of U.S. stocks, but it is a specific sector of technology stocks. Indices that are composed of specific types of stocks might be more liable to be statistically predictable on the short side.

If we look back through the NASDAQ 100 Index from 1997 to 2021, we can see that it also has a long bias: in an average week during this period, it rose by 0.12%. Again, it is impossible to construct a profitable momentum strategy on the short side.

Geographical Discrimination

What if we look at a stock market outside the United States? This might give us an example where we can construct a better model for predicting short-term direction profitably on the short side. One good example to use might be the Japanese Nikkei 225 Index, as it is well-known that the Japanese stock market has underperformed during recent decades.

Firstly, if we look back from 1997 to 2021, overall, there is a SHORT bias here: over the average week, the index fell by 0.28%. So, it is no surprise that it is possible to construct a profitable model for the short side with this stock index. Let’s see what happens when we apply the 3 months / 6-month test to the Nikkei 225 Index:

Long weeks: 388 trades, average weekly performance =+0.05%

Short weeks: 353 trades, average weekly performance = +0.20%

Here we have a model that is profitable at both ends.

Bottom Line

To summarize the meaning of “long” and “short” trading in the simplest terms possible, it can be said that a long trade is one where you profit when the price goes up, while a short trade is one where you profit when the price goes down. That is essentially all you need to know.

In Forex, there is no real difference between a “long” or a “short” trade, because in every Forex trade you are always long of once currency and short of another.

In commodity or stock trading – whether stock market indices or individual stocks – there is a more significant difference between long and short trades because these markets tend to behave differently when they are falling to when they are rising, with falls tending to be fast and volatile compared to rising periods. Overnight swap rates are also nearly always considerably higher in short trades in these asset classes.

FAQs

What does long and short mean in trading?

“Long” means your trade makes profit when the price rises. “Short” means your trade makes profit when the price falls. In Forex, you are always “long” one currency and “short” another when you open a trade. In stock trading, you typically must borrow shares and pay interest on them when you go “short”.

What does going short mean in trading?

A short in stock trading is where you borrow shares you do not own to sell, hoping the value will go down so you can then make a profit from buying them back and returning them to the loaner. A short trade must usually be financed by a daily interest payment to the loaner, plus the payment of amounts equal to any dividends issues while the trade is open.

Can you long and short the same stock?

You can long and short the same stock, although some brokers do not allow this “hedging”. Even if it is allowed, it usually makes no sense if the trade quantities long and short are the same sizes.

What is a long / short strategy?

A long / short strategy is when you buy some shares (going long) while simultaneously selling (going short) other shares. If the long and short positions are evenly sized, such a strategy is theoretically “market neutral”, meaning it can profit whether the stock market overall rises or falls, if the choice of out and underperforming stocks is good.

What does trading long mean?

Trading long means that you have entered a trade hoping that the price will go up. You will make money if the price rises and lose money if the price falls. A long trade is a classic “buy” trade.

When do I use a long or short trade?

You use a long trade to profit when you expect the price of something will rise, or a short trade to profit when you expect the price of something to fall.

Why is it called “long” and “short” position in trading?

The terms “long” and “short” in trading have been in use for centuries and their exact origin is unclear. The term “short” was historically taken to mean undervaluing something, and “long” would be the natural opposite of that, which may explain the origin of these terms.

Adam Lemon

Adam Lemon began his role at DailyForex in 2013 when he was brought in as an in-house Chief Analyst. Adam trades Forex, stocks and other instruments in his own account. Adam believes that it is very possible for retail traders/investors to secure a positive return over time provided they limit their risks, follow trends, and persevere through short-term losing streaks – provided only reputable brokerages are used. He has previously worked within financial markets over a 12-year period, including 6 years with Merrill Lynch.
Learn more from Adam in his free lessons at FX Academy

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