Theory•Trading

Short Selling? Long Buying? Finally a Simple Explanation

October 19, 2021 by Benjamin

Short selling and long buying are terms used in stock trading. They were in the news not least because of the so-called «short squeeze» at the beginning of the year in connection with the Gamestop share. The film The Big Short is also dedicated to this topic: A hedge fund manager who saw the financial crisis coming in 2007 and therefore made an enormous profit with short positions.

The Gamestop short squeeze and the financial crisis of 2007/2008 are directly related. Many small investors saw the squeeze as revenge against the large hedge funds, which contributed heavily to the financial crisis.

What is short selling?

Short selling, shorting, opening a short position, or going short all mean the same thing. You sell an asset that you don’t own and you insure that you will buy back this loaned asset at some point in the future. In other words, you are betting that the price will drop in the future.

Compared to long positions, going short is used more in bearish times. Namely, when the prospects of large price increases are pessimistic.

Example 1:

  • The Bitcoin price on 01/01/20 is $10,000.
  • You think the price is overvalued and therefore bet $1’000 that the price will be lower on 03/31/20.
  • On 03/31/20 the contract expires and the Bitcoin price is $8,000.
  • Since the price is 20% lower, you get 20% profit: +$200
Example chart of how the price develops when a stock is shorted. At the price of $10,000 per BTC, the short position is opened on 01/01. On 01/15 the price is at $11,500, which means a loss of 15%. On 01/31 the price is at $11,000: still a loss of 10%. On 02/15 the loss increases to 12% with a price of $11,200. Then the price drops to $9,700 on 02/29 and thus the first gain of 3% is achieved. The price drops further to $8'600 (gain: 14%) and then finally to $8'000 on 03/31, which means a gain of 20%.
Example development of an asset price and the associated short selling profit

Example 2:

  • The Bitcoin price on 01/01/20 is $10,000
  • You think the price is overvalued and therefore bet $1,000 that the price will be lower on 03/31/20.
  • On 03/31/20 the contract expires and Bitcoin is traded at $12’000.
  • Since the rate is 20% higher, you make a 20% loss: -$200

What does «betting» mean in the context of short selling?

With a short sell bet, you explicitly sell an asset that you do not own yourself. This can be a certain number of shares or a fraction of a cryptocurrency.

In the examples described above, this means that you would sell $1,000 worth of Bitcoin and then buy back the same quantity after three months.

  • 01/01: Sell 0.1 BTC for $1,000
  • 03/31: Buy 0.1 BTC für $800 (0.1 BTC * $8,000 = $800)

Since you never owned the Bitcoin but only borrowed it, you also do not own it after the buyback. You have to «give it back» again. In the event of the Gamestop shares short sale from the beginning of the year, the big hedge funds had shorted more shares than even existed. Many shares were thus borrowed and sold several times 🤯.

In addition to shorting stocks, futures contracts on stocks can also be shorted. You can find a simple and understandable explanation of futures here: Futures contracts for dummies – a simple explanation

Risks when betting on a falling price

If you buy a share hoping that the price will rise, then your risk is limited and your profit theoretically unlimited. The worst thing that could happen would be if the company goes bankrupt and the stock has no value anymore. Because the share cannot fall below 0, right?

Let’s have a look at the example of Bitcoin again: You buy 1 BTC for $10,000 on January 1. After a brief rise, the cryptocurrency is unexpectedly banned and the price crashes in the following months. Since you believe in a recovery, you don’t sell. Unfortunately, your hope doesn’t come true and Bitcoin isn’t worth a dime on May 15. Your loss: $10,000.

Chart that illustrates the risk when buying an asset (long buy). The following data is visible: Purchase at a price of $10,000 on January 1. The price first rises by 15% and then falls to 0 by May 15.

In contrast, with short selling, the possible profit is limited, but the potential loss is unlimited. If you had gone short in the above example instead of buying BTC, you would have made a profit of 100%. However, betting on the wrong price direction can also be a disaster.

Chart that illustrates the risk of short selling. The following data is visible: Purchase at a price of $10,000 on January 1. The price rises to $20,000 on February 29th (loss 100%), then to $30,000 (loss 200%) on March 31st and further to $40,000 (loss 300%) on April 15th until it reaches $50,000 on May 15th. On May 15th, the investor has thus incurred a loss of 400%.
Example asset price development and the associated risks of short sell

Let’s assume you short 1 BTC at a price of $10,000. If the price rises to $20,000, you have burned the entire $10,000 you invested. But that’s not the end of it: If you don’t close your short position, your losses can increase indefinitely.

The example above shows the risk somewhat dramatically and of course such a loss of an investment would only be possible if a corresponding collateral was deposited on the trading platform. But the message is clear: Manage your risks!

Short selling and its bad reputation

The number of short positions can be viewed publicly. Consequently, one can check at any time how many shares of a company have been shorted. If this is a huge number, investors become skeptical. This often leads them to sell their holdings as a precaution instead of missing out on a price drop.

For example, the number of currently shorted Gamestop shares can be seen on marketbeat.com. As of today (10/18/21), this is 7,820,000 shares. Of course, this is nothing compared to the beginning of the year, when about 140% of all Gamestop shares were being shorted.

Volume of shorted Gamestop shares as of 10/18/2021. The table shows that there are 7,820,000 short positions open at the current time. In the previous month, there were 7,380,000 shares. This corresponds to an increase of 5.96% compared to the previous month.

When a company gets into trouble, the hyenas of Wall Street awaken: The hedge funds. They give the ailing companies the death blow by shorting huge amounts of shares. More investors then sell their holdings out of fear, causing the share price to plummet.

The hedge funds are well aware that they are destroying a company in the process. But the certain profit from short selling is too tempting. Well, the almost certain profit, as could be seen in the example of the Gamestop share.

The great Gamestop short squeeze of 2021

As mentioned above, various hedge funds invested in the downfall of the Gamestop stock. Consequently, large amounts of short positions were open, which were to be fulfilled at the end of January 2021.

A Reddit user had been documenting his investments, gains and losses with the Gamestop stock on the forum since 2019. As the short positions of the hedge funds are publicly visible, the private investor became aware of it and increasingly wrote about it on Reddit. A mob evolved, which bought so many shares that the price rose to $340 in the meantime. On January 29, the hedge funds’ loss amounted to 19 billion U.S. dollars.

Chart of the Gamestop share price. The share price rose from $40 in early January to $325 on January 29. By October 2021, the price moves between $150 and $200.
Screenshot created on Google

When all the action was going on, I was browsing the Wallstreetbets forum on Reddit and I was intrigued. In particular, an open letter from user ssauronn, who was affected by the 2007/2008 financial crisis, had me hooked: An Open Letter to Melvin Capital, CNBC, Boomers, and WSB

The person was clearly serious and willing to take a very big risk.

I bought shares a few days ago. I dumped my savings into GME, paid my rent for this month with my credit card, and dumped my rent money into more GME. And I’m holding.

What are long positions?

In contrast to short selling, investors open long positions especially in optimistic times. If an investor goes «long» with a stock, he expects the stock to rise. Basically, this is already the case when an asset is bought to sell it again in the distant future.

However, investors usually use the term to refer buying a call option. In doing so, the investor secures the option to buy an asset at a previously agreed price in the future. Since the investor is optimistic, he expects the price to be higher than his purchase price. Of course, the option to decide to buy at a later time comes at a cost.

Some may ask, why not just buy the asset if its price will rise in the future? Long positions with call options are more about reducing risks. Let’s take a look at the following two illustrations.

Chart showing the profit or loss in contrast to a long position with a purchase in the spot market depending on the price. If you buy 100 shares at a price of $50, then you have already made a profit of $100 with a share price of $51. However, the price can also go down and with every $1 a loss of $100 is made.
Loss or profit depending on the share price for a purchase of 100 shares at $50 each

For example, if one buys 100 shares of $50 each, then each increase of $1 in price means a profit of an additional $100. But the same applies also in terms of loss, where 100% or in this example $5,000 loss could be realistic. With the use of call options the risks look a bit different.

Comparison of the profit on a long position with 100 shares of $50 each with a fee of $3 per share. Because the fee must be paid in any case, the maximum loss is -$300. From a price of $53 the loss is 0. Everything above $53 is considered a profit.
Loss or gain depending on the share price for a purchase of 100 options at $50 each with a fee of $3 per share

Since in the example above the option costs $3 per share, a maximum loss of $300 can be expected, provided that the share price does not exceed the $53 mark by the expiration date of the contract. Compared to a normal buy in the spot market, the investor only realizes a profit from a price of $53 and not already from $50. In return, the risk of loss is strongly limited.

Long put option as an alternative to short selling

When speaking of long buying, one usually speaks about call options. However, put options are also considered long positions. Like short selling, they are used more often in the bear market. In contrast to call options, two parties agree on a price at which one party is entitled to sell the asset. The seller therefore expects a lower value at the time of sale than the sales price agreed upon.

My experience

Long positions with call option have not found any use with me, since I do not approach speculations yet. Instead I go long by just buying in the spot market and holding the asset to sell at a later date.

Short selling, on the other hand, is a powerful trading method that can be used for arbitrage trading on cryptocurrency platforms. This gives you a chance to earn a high return with low risk (yes, that’s possible! 💸💸💸). You can find a simple explanation with practical instructions here: Contango: Your Chance for a Low-Risk Profit