The Long and Short of It

The financial markets are filled with colorful terminology.

And one of the biggest obstacles that new option investors face is

interpreting the jargon. Two common terms used by brokers and

traders are “long” and “short,” and it’s important to understand

these terms as applied to options.

If you buy any financial asset, you are “long” the position. For

example, if you buy 100 shares of IBM, using market terminology, you are long

100 shares of IBM. The term “long” just means you own it. Likewise, if you buy a

call option, you are “long” the call option.

If “long” means you bought it then “short” means you sold it, right? Not quite.

Some people will tell you that “short” just means you sold an asset, but that is an

incomplete definition. For example, if you are long 100 shares of IBM and then

sell 100 shares you are not short shares of IBM even though you sold 100 shares.

That’s because you bought the shares first and then sold them, which means you

have no shares left.

However, let’s say you bought 100 shares of IBM and then, by accident, entered

an order online to sell 150 shares of IBM. The computer will execute the order

since it has no way of knowing how many shares you actually own. (Maybe you

have shares in a safe deposit box or with another broker.) But if you really owned

only 100 shares then you would be “short” 50 shares of IBM. In other words, you

sold 50 shares you don’t own. And that’s exactly what it means to be short shares of

stock. It means you sold shares you do not own. However, when we short shares in

the financial market, it’s not meant to be by mistake – it is done intentionally. How

can you intentionally sell shares you don’t own? You must borrow them. In order

to further understand what it means to be “short” and how that applies to options,

let’s take a quick detour to understand the basics of short selling.

Traders use short sales as a way to profit from falling stock prices. Assume IBM

is trading for $70 and you think its price is going to fall. If you are correct, you

could profit from this outlook by entering an order to “short” or “sell short” shares

of IBM. Let’s assume you decide to short 100 shares. Your broker will find 100

shares from another client and let you borrow these shares. Although this sounds

like a lengthy, complicated transaction it takes only seconds to execute.

In terms of the mechanics, shorting shares is similar to making a purchase on

your credit card. Your bank finds loanable funds from somebody else’s account

to let you borrow and you then have an obligation to return those funds at some

time. How complicated is it to short shares of stock? About as complicated as it is

to swipe a credit card at a cash register.

Let’s assume you short 100 shares of IBM at $70. Once the order is executed,

you have $7,000 cash sitting in your account (sold 100 shares at $70 per share)

and your account shows that you are short 100 shares of IBM – you sold shares

that you do not own. Do you get to just take the $7,000 cash, close the account

and walk away? No, once you short the shares of stock, you incur an obligation to

replace those 100 shares at some time in the future. In other words, you must buy

100 shares at some time and return them to the broker. Obviously, your goal is to

purchase those 100 shares at a cheaper price.

Let’s assume that the price of IBM later drops by $5 to $65 and you decide to

buy back the shares. You could enter an order to buy 100 shares and spend $6,500

of the $7,000 cash you initially received from selling shares. Once you buy the 100

shares, your obligation to return the IBM shares is then satisfied and you are left

with an extra $500 in your account. In other words, you profited from a falling

stock price. This profit can also be found by multiplying the number of short

shares by the drop in price, or 100 shares * $5 fall in price = $500 profit. If you

have shorted 300 shares of IBM, you would have ended up with a 300 shares * $5

fall in price = $1,500 profit. Of course, if the price of IBM had risen at the time

you purchased them back, then you’d be left with a loss since you must spend more

than you received to return the shares. If short selling still sounds confusing, just

realize that the short seller generates profits in the same way as a stock buyer but by

entering transactions in the opposite order. For instance, when you buy stock, you

want to buy low and sell high. When you short stock, you want to sell high and

buy low. If you short a stock and then buy it back at a higher price, you’re left with

a loss because you really bought high and sold low.

Short selling works because traders are obligated to return a fixed number of

shares and not a fixed dollar amount. In our example, you shorted 100 shares with

a value of $7,000. Your obligation is to return 100 shares of IBM and not $7,000

worth of IBM. If you can purchase the shares for less money than you received,

you will make a profit.

This is not meant to be a course in shorting stocks but rather a way to understand

what the term “short” really means when applied to the stock or options market.

Shorting means you receive cash from selling an asset you don’t own and then incur some

type of obligation.

In the case of shorting stocks, your obligation is that you must

buy back the shares at some time.

If you short an option, you have sold something you don’t own. You get

cash up front and then incur some type of obligation depending on whether

you sold a call or put. If you short a call, you get cash up front and have the

obligation to sell shares of stock. If you short a put, you get cash up front and

have the obligation to buy shares of stock. The cash is credited to your account

immediately and is yours to keep regardless of what happens to the option. That

is your compensation for accepting an obligation, much like the premiums you

pay to an insurance company.

When you sell (short) an option you will receive cash, which is yours to keep

regardless of what happens in the future.

The following table may help you to visualize the rights-versus-obligations

relationships:

LONG SHORT

Call

Right to buy stock Obligation to sell stock

Put

Right to sell stock Obligation to buy stock

Notice that the long and short positions are taking opposite sides of the

transaction. For instance, the long call (call buyer) must be matched with a short

call (call seller). The long call has a

right while the short call has an obligation.

Rights and obligations are opposites. In addition, the long call gets to

buy while the

short call is required to

sell. Buying and selling are also opposites.

For put options, the long put (put buyer) must be matched with a short put

(put seller). As with call options, it is the long position that has the

right while the

short position has the

obligation (opposites). The long put, however, has the right

to sell while the short put is required to buy (opposites).

This arrangement is required to make the options market work. Both parties

(the buyer and seller) cannot have rights. They can neither both buy nor both sell.

One side has the right to buy (or the right to sell), while the opposite side has the

obligation to complete the transaction.

This arrangement is often a source of confusion for new traders. They wonder

how the option market can work if everybody has a right to buy or sell. The answer

is that it is only the

long position that has the rights. The short position has an

obligation. It is important to understand this relationship when going through this

book, especially when you get to strategies.

Long options have rights. Short options have obligations.

Getting Out of a Contract

We just learned that you can get into an option contract by either

buying or selling a call or put. But once you’re in the contract, is there a

way to get out of it at a later time? The answer is yes. All you have to do

is enter a

closing transaction (also called a reversing trade). In other words, you can

always “escape” your obligations by simply doing the reverse set of actions that got

you into the contract in the first place.

For example, if you are short an option and decide at a later time you don’t want

the corresponding obligation, you can get out of it by simply

buying the options

back. This is much like you do with shares of stock if you are short. However, just

because you can get out of the contract doesn’t mean that you can avoid any losses

that may have accrued. The price you pay to get out of the contract may be higher

and, in some cases, much higher than the price you originally received from selling

it – just as when shorting shares of stock. But the point is that you can get out of a

short option contract by simply buying it back.

If the idea of buying back a contract sounds confusing, think of the following

analogy. You probably have a cell phone are locked into some type of agreement such

as a one-year

contract. Cell companies do this to prevent people from continually

shopping around and jumping to the hot promotion of the month. However, your

cell provider will also have some type of “buy back” clause in the contract. That is,

if you wish to get out of the agreement, you must pay a fixed amount of money,

perhaps $200, and you can escape your remaining obligations. If you pay this fee,

the company cannot take you to court later and say that you didn’t fulfill your

obligations. The reason is that you bought the contract back – it no longer exists

between you and the company. That’s the fee they specified to end all obligations.

This is mathematically the same thing that happens when you buy back a

contract in the options market. Although it is not a fee to end the contract, what

you’re really doing is going long and short the same contract, thereby eliminating

all profits or losses beyond that point. If you’re long the contract and you’re short

the same contract, then you’ve effectively ended all obligations.

Likewise, you can get out of long call option by simply doing the reverse;

that is, selling the same contract that you own. Because of this possibility, most

option traders simply trade the contracts back and forth in the open market rather

than using them to buy or sell shares of stock. As we will later see, trading option

contracts is a big advantage because they cost a fraction of the stock price.

You can always get out of an option contract at any time by simply entering

a reversing trade.

Let’s make sure you understand the concepts of long and short calls and puts

by using our pizza coupon and car insurance analogies. If you are in possession of

a pizza coupon, you are “long” the coupon and have the right, not the obligation,

to buy one pizza for a fixed price over a given time period. In the real world, you

do not buy pizza coupons; they are handed out for free. But that doesn’t put an

end to our analogy because the basic idea is still there. Since you are holding the

coupon, that means you posess the right to use it, and that’s the role of the long

position. The pizza storeowner would be “short” the coupon and has an

obligation

to sell you the pizza if you choose to use your coupon. You have the right; he has

the obligation.

If you buy an auto insurance policy you are “long” the policy and have the

right to “put” your car back to the insurance company. The insurance company

is “short” the policy; it receives money in exchange for the potential obligation of

having to buy your car from you. Whether you make a claim or not, the insurance

company keeps your premium just as you will when selling options. That’s its

compensation for accepting the risk.

In the real world of car insurance, you cannot just force the insurance company

to buy the car back for any reason. There are certain conditions that must be

met; for example, the car must be damaged or stolen. You can’t just obligate the

insurance company because you don’t like it anymore or because it has depreciated.

However, in the real world of put options, you can sell your stock at a fixed price

for

any reason while your put option is still in effect. There are no restrictions. Of

course, you wouldn’t want to do that if the fixed price you’d receive is less than the

current market price. The main point is that if you are long a put option, you call

the shots. You have the rights. You have the “option” to decide. You have the right

to sell your stock for that fixed price at any time during the time your “policy” is

in effect.