Stocks go up. Stocks go down. Investors and speculators alike can benefit from the fluctuations, and it all starts with understanding which side of a stock's movement you want your money riding on.
The obvious choice -- and the most common route -- is take a long position. This is when you buy a stock outright, initiating a position that will be profitable if a stock moves higher. Folks tend to be attracted to stocks of companies that they see moving higher, and many investors only limit themselves to playing this side of the wager. Going long is such a popular trade that it's rarely described that way. You may be initiating a long position, but simply saying that you're buying a stock is enough. Investors know what it means.
Things get a little more complicated when you initiate a short position, looking to cash in when an investment heads south.
Researching a stock doesn't always end with bullish assertions. After reviewing a company's market position, future prospects, and current valuation you may arrive at the conclusion that the stock will head lower -- not higher.
Many investors will simply move on, continuing the search for a different stock that has the potential to beat the market. However, opportunistic traders with bearish convictions and the means to stomach the risks of riding a stock lower can decide that initiating a short position is the smarter way to go.
Selling a stock short, in theory, reverses the long process. Initiating a short position involves selling the stock first -- selling it short -- and then buying it back to zero out or cover the position. It's not always easy to execute. A short seller's broker has to have access to shares that can be borrowed to execute the trade. There are also some unique restrictions in selling short a security including naked shorts and a recently revised alternative uptick rule.
Short sellers aren't a rare commodity in and of themselves. Sirius XM Radio is routinely one of the most shorted stocks on the market in terms of the number of shares sold short. There were nearly 150 million shares of the satellite radio provider sold short as of the end of April.
Risks of long positions vs. short positions
The biggest risk to shorting a stock is the unlimited downside risk. Investors initiating a traditional long position can lose everything if a stock goes to zero, but there is more at stake for those shorting a stock.
If an investor shorts 1,000 shares of a $5 stock -- a $5,000 investment -- and the stock triples to $15, covering that short would require $15,000 to buy back those 1,000 shares. This is the risk that sometimes triggers what they call a short squeeze as shorts scramble to close out their bearish positions on a stock that's moving higher.
At the end of the day, long and most short positions are perfectly legal. There is money to be made on either side of a trade, and that holds particularly true for the market's more volatile stocks. Long position? Short position? As long as you're comfortable with your bullish or bearish convictions, understand the dynamics of complete the transaction, and accept the risks that accompany the potential rewards, then you will be ready to trade the good and the bad of everything that the market has to offer.
Rick Munarriz has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.