A position in an asset describes how much of the asset an investor owns. The investor can either have a long position, meaning the investor owns the asset or has borrowed money to purchase the asset, or the investor can have a short position, meaning the investor sold the asset without owning it.
An investor generally has a long position in a contract if they will take physical delivery of the underlying asset or its cash equivalent, and a short position if they are liable for delivery of the asset.
For options contracts specifically, the long investor has the right to exercise the option and the short investor must satisfy the obligation if exercised. Describing option positions in this way can be confusing in the case of put options, which give the holder the right to sell the underlying asset. So an investor that purchases a put option has a long position in the option but is considered to have short exposure to the underlying asset. For example, if an information-motivated trader believes that Apple’s stock is overvalued, he can effectively bet against the stock by buying put options on the stock. Since the trader has the right to exercise the option, he has a long position in the puts. However, because the long put position effectively bets on a decrease in Apple’s share price, the trader is considered to have short exposure to Apple’s stock.
For swap contracts, the long side benefits from an increase in the price of the underlying asset. In the case of currency contracts, an investor has a long position in the currency being bought and a corresponding short position in the currency being sold.
An investor can take a short position by borrowing shares of a stock from a securities lender and then selling them. Securities lenders require short sellers to post the proceeds from the stock sale as collateral for the loan. The proceeds are then invested in short-term securities, with interest being returned to the short seller at the rebate rate. In some cases, the rebate rate may be negative – meaning the short seller is paying the lender to invest the sale proceeds, but usually the rebate rate is 10 basis points less than the overnight lending rate. The difference between the overnight lending rate and the rebate rate is the loan fee that the securities lender receives for its services.
While the losses from a long position are limited to the price paid for the security, losses from shorting a stock are theoretically unlimited because the short seller is obligated to return the security, which doesn’t have a price cap. Similarly, the long investor stands to benefit from unlimited gain potential while the short seller can only gain the total proceeds from the initial sale (if the stock price of the shorted security drops to zero, the short seller eliminates their obligation for free).
In many markets, traders can borrow securities through margin loans at the cost of paying the call money rate on the loan. Similar to a down payment on a house, the borrower must put up a minimum of their own equity, the initial margin requirement, in the purchase. To protect brokers against losses in leveraged positions, traders must keep an amount of equity in their positions that is greater than or equal to the maintenance margin requirement (usually 25%). If share prices fall and equity drops below the maintenance margin requirement, the trader will receive a margin call to restore equity back to the required level. If additional equity is not contributed, the broker will close out the position to prevent further losses.
A trader sells 10,000 put options on the stock of ZYX. What is this trader’s position relative to the option and exposure to ZYX’s stock?
A. Long position in the put options, short exposure to ZYX’s stock
B. Short position in the put options, long exposure to ZYX’s stock
C. Short position in the put options, short exposure to ZYX’s stock
The correct answer is B.
Since the trader sold the options, she is obligated to fulfill the contract if the option is exercised and therefore has a short position in the put options. However, the trader stands to lose if the price of ZYX falls below the strike price of the options as she will be obligated to buy ZYX shares above market price. So the options trader is betting against a price decline in the stock and thus has long exposure to the stock.
Reading 44 LOS 44e:
Compare positions an investor can take in an asset