In a long position, the owner benefits when the stock or share gains in value. The potential profit is unlimited. So the “long” position is said to be “bullish.” When the stock is down, the most that the owner can lose is the amount of money he has originally paid for it. Since it is impossible to lose more, it is said that the owners have “limited liability.”
A Long Position
Example of a Long Position
Suppose a share is purchased at $60, if the share value doesn’t change the owner’s profit will be $0. If the share grows in value up to $100, the owner’s profit is $40. If the share price drops to $30, the owner’s loss will be $30.
In Short Selling the borrower borrows a stock from an owner in exchange for an IOU, and then sells it to a buyer. When the market value of the share is down, the borrower buys it and returns to the original owner.
Say for example that a short seller borrows 1 GM Stock from the owner in exchange for the borrower’s IOU. The borrower sells 1 GM share to a buyer for $60. If the market value of 1 GM drops to $50, the borrower gets $10.
This way the person, who is in the “short selling” position, gains a profit when the share price drops in value. The maximum profit is equal to the amount the share was originally purchased for. However the maximum potential loss can be unlimited. That’s why short selling is considered to be “bearish”.
A Short Position
Example of Short Selling
Suppose the borrowed share has a present value of $60; if the share price doesn’t change, the short seller’s profit will be $0.
If the borrowed share’s price goes up in value up to $70, the short seller’s loss will be (-$10).
If the borrowed share’ price drops in value up to $50, the short seller will make a $10 profit.
Questions about the Stock Market
1. Why lend stock?
There’s no reason not to, its convenient and is as good as an IOU. However, when you lend you lose your voting rights. When you short sell, the short seller gives the owner of the stock an IOU of the same share.
2. How long does a short position last?
A short position lasts till the two parties agree, however if one party wants to leave, then the broker re-matches the deal.
3. Who has voting rights in a firm?
The person in physical possession of stock certificate.
4. How does the firm know who to pay the dividend to?
If a company pays out dividend and the owner has lent the stock, then the person who has borrowed the stock has to pay the actual owner. Also, ownership is tracked by a transfer agent.
5. What is the rate of return for a short seller?
Short seller gets cash (interest) and has to pay dividends. So, rate of return = interest received – dividends paid.
6. What is a short squeeze?
For example, there are 1 million genuine shares and 2 million IOU’s (hypothetical shares). If all 2 million IOUs are demanded at once then the short seller has to buy 1 million shares, which increases the price of the share and the short seller loses.
7. Does the short seller pay interest on the borrowed stock?
The short seller doesn’t pay interest however actual interest if disguised as a trading fee.
8. What the effects of short selling on stock price?
Short selling has no effects on the price of the stock.
9. What is the effect on stock price with the issuance of new stock?
There is no effect on the stock price when new stock is issued.