When it comes to understanding the long and short of investing, most beginning investors must learn what seems like a new language. In fact, the phrase "the long and the short of it" originated in financial markets.
In this article we discuss several key terms that will help you better understand and communicate with other market participants. These terms are used in the equities, derivatives, futures, commodities and forex (or currency) markets. You will learn what buying, selling, and shorting really mean to investors and how they can use certain terms interchangeably with more confusing words like bullish and bearish. To compound the issue, options traders add in a few other terms such as "writing a contract" or "selling a contract." When you start to communicate about the markets more comfortably, you will be better informed and can make wise investment decisions.
Long Positions and Shorting
The financial markets allow you to do a few things that are really common in everyday life and a few things that aren't. When you buy a car, you own that car. In the stock market, also known as the equity market, when you buy a stock, you own that stock. You are also said to be "long" on the stock or have a long position. Whether you are trading futures, currencies or commodities, if you are long on a position, it means you own it and hope it will increase in value. To close out of a long position, you sell it.
Shorting will likely seem somewhat foreign to most new investors, because shorting a position in the equity market is selling stock you don't actually own. Brokerage firms allow speculators to borrow shares of stock and sell them on the open market, with the commitment to eventually return the shares. The investor will then sell the stock at the day's price in the hope of buying it back at a lower price while pocketing the difference. Catalog companies and online retailers use this concept daily by selling a product at a higher price, and then quickly buying it from a supplier at a lower price. The term originates from a situation where a person tries to pay a bill but is "short" on funds.
You may be interested to know that some people consider shorting to be unpatriotic or "bad form." The phrase "don't sell America short" was attributed to John Pierpont Morgan Sr. (J.P. Morgan). The debate against short selling rages on to this day.
The Currency Caveat
When trading foreign currencies in the "spot" market (currencies and many commodities are traded in the futures or spot markets), you are usually long one currency and short another. This is because you are exchanging one currency for another and therefore, various world currencies trade in pairs.
For instance, if you think the U.S. dollar is going to rise but the euro is going to fall, you could short the euro and be long on the dollar. If you feel the dollar is going to rise and the Japanese yen will fall, you could be long on the dollar and short on the yen.
Bullish vs. Bearish
Other terms that are often new to beginning investors are "bullish" and "bearish." The term bullish is used to describe a person's feeling that the market will go up, while bearish describes a person who feels the market will go down. The most common way people remember these terms is that a bull attacks by ducking its head and bringing its horns upward. A bear attacks by swiping its paws down.
Chicago is the home of commodity and futures markets; coincidentally, the professional basketball team is the Bulls and the professional football team is the Bears. The Chicago Cubs' mascot is a bear cub.
It is also common for investors to use the terms "long" or "short" to describe their market sentiment. Instead of saying they are bullish on the market, investors may say they are long on the market. Similarly on the downside, investors may say they are short on the market instead of using the term bearish. Either term is acceptable when describing your market sentiment. It is important to remember that short and long usually imply that you have a certain position in whatever market you are trading but, as you can see, this isn't always the case.
Calls vs. Puts
The derivative market is also known as the options market. Options are contracts in which one party agrees to buy or sell a certain security (security is a generic term for any financial product) at a set price and set time from or to another party. Options are very common in the equities market but are also used in the futures and commodities markets. The forex (or currency) market is known for very creative derivatives known as "exotic options."
For our purposes, we'll refer to options in the stock market since it is most investors' first introduction to derivatives.
Options come down to calls and puts.
Call options give the contract buyer the right to purchase stock shares at a set price on or before a set date. Usually another investor will sell a call contract, which means they believe the stock will stay flat or go down. The person who buys the call is long on the contract, whereas the person who sells the contract is short.
A put option allows the contract buyer to sell stock at a set price before a set date. Like a call option, there is usually another investor willing to sell the option contract, which also means that investor believes the stock will either stay about the same price or rise in value. So the person who buys the option contract is long on the contract and the person who sells the contract is short.
Selling options while using the derivative dialect also gets more complicated because, not only do they use the terms "sell" or "short" regarding the contract, option traders will also say they "wrote" a contract. Today, the contracts are standardized and no one really "writes" the contract, but the term is still very common.
Covered calls are often one of the first option strategies investors learn—these involve the purchase of a stock and the sale of a call contract at the same time. The purchased stock acts as "collateral" in case the call is exercised by the option buyer and the seller can relinquish the shares while keeping the premium gained for selling the option. Since investors are buying a stock and selling a call at the same time, they use a "buy-write" order.
The Bottom Line
At this point, you may find yourself going back to reread some of the vocabulary that was just discussed. Let's do a quick recap. Investors will either say they are bullish, or long, on the market—or bearish, or short, on the market. If we are long one currency in the forex spot market, we are short another currency at the same time. This can be confusing but not nearly as confusing as the options market.
In the options market, we can say we are bullish on a stock and then short a put because while being bullish, we can either buy a call or sell a put. We can be bearish on a stock and be long on a put because if we are bearish, we can either buy a put or sell a call. This may also mean that we are short on the market by going long on a put or long the on market by shorting a call. You can imagine the linguistic laughter that comes from a group of option buyers talking to each other.
In many cases, and not just in the financial world, overcoming the language barrier will be one of the vital keys to success. Investing carries with it its own language barriers that must be broken down by translating the terms and subduing the syntax.