3 – M1L6 04 Long And Short Positions V3

Once you have found a signal that seems to indicate the future performance of a stock, it is time to put it to action. For instance, if you think that a stock has upward momentum, you might want to buy some shares and hold onto it for a fixed period of time, or until you start seeing the stock fall. This is known as taking a long position on the stock. When you sell your stock, hopefully, at a higher price than you bought it, that is known as closing your position. But what if the stock has a downward momentum? And you believe that it is going to keep falling for some time? In this case, you can take what is known as a short position on the stock, selling first and then buying back later, hopefully, at a lower price. If this is the first time you’re hearing about shorting, it might sound bewildering. But what it boils down to is borrowing shares from someone, usually your broker, and then promising to return them once your short position is closed. The brokers incentive here is that they typically earn a commission on the profit you make from the short sale. At the same time, they are taking a risk. What if you bail out and never buy back the shares? For this reason, brokers typically require you to keep some money in a margin account that they can charge if you fail to keep your promise. The whole process of short selling is a bit more complex with interests, fees, and margin calls coming into the picture. But, all you need to know when evaluating a potential trading signal is that shorting is one possible action you can take. So, when you think a stock is going up, you can buy or go long, and if you believe it is going to keep falling, you can short it. However, dealing with individual stocks can be tricky and unpredictable. You don’t want to put all your eggs in one basket. Therefore, it is recommended to adopt a cross-sectional strategy, where you invest in multiple stocks at the same time. One smart way to do this is to use your signal to rank order the stocks, and use the rankings to select stocks for long and or short positions. For instance, if you’re using a momentum signal, the top performers are likely to keep rising, so you can go long on them, and the bottom performers, that are falling, are likely to keep falling. So, you can short them. This has the added benefit that you’re using the relative performance of stocks to compare them.

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