One way in which capable speculators differ from both Joe Sixpack and traditional investors is the willingness and ability to take short positions.  In finance parlance, when you exchange your money (usually, dollars) to buy something you’ve gone “long” that thing.  If you then sell that something back (again receiving dollars), you’re “flat” – which means you have no position except for cash.  If you’re flat and sell something you don’t have, receiving yet more cash in return, you’re “short” – you have a negative position in the security in question.  When you use that extra cash to buy back what you never had in the first place, closing the short position, you have “bought to cover” or just “covered” your short, and are again flat.

Now all of this shorting business may seem a little odd if your experience with finance up to this point revolves around conventional stock investing.  It might even sound dangerous, unethical, or illegal.  The media loves to (mostly incorrectly) blame short sellers for market drops.  But the reality is that in most markets, there is nothing wrong with taking a short position if so desired, and many markets would in fact totally fail to function without the ability to take short positions.  There are some cases where shorting can be problematic both for an individual and for the market as a whole, but they are exceptions rather than the rule.

The easiest way to understand shorting is to step away from stocks for a second and talk about commodity futures.  Futures are what is known as a derivative, which is a kind of contract.  That sounds much more complicated than it actually is.  Let’s say I’m a refinery – I refine oil into gasoline.  In order to do my business, I have to have oil to refine, not just today but in the future.  So I enter into a contract with someone who owns oil wells to deliver oil at a mutually agreed upon pipeline at some date in the future – say, the first of next month.  In return, when the oil is delivered, I will pay a specific price.  These sort of agreements for future delivery are a standard part of business at all levels.

Another way to think about this oil contract is that the refinery has gone long oil, or more specifically future oil, by exchanging money for it.  The well operator has gone short future oil and received money for it.  In this case, the refiner is going to get back to a flat position not by re-selling the oil in the market, but by refining it out of existence.  Similarly, the well operator is going to get flat by producing the oil from wells, not by buying to cover.  But the key point here is that you can’t have this sort of business relationship without the ability to take both long and short positions.

To simplify matters slightly, most commodities are traded in the form of futures contracts as described above but those contracts are standardized.  The quantity, quality, location of delivery and time of delivery are standardized.  All that’s left variable is the price.  Furthermore, the contracts are guaranteed by a central clearinghouse, so if one party violates the contract the clearinghouse will make good.  That makes the contracts fungible, and as a result the contracts can then be traded on an auction market just like you would stocks.  In the US, the Chicago Merchantile Exchange and their extended “CME Group” of exchanges handle the bulk of standardized futures trading.  In case you’re curious, the oil contract has the ticker CL and is one of their most popular contracts.  I trade it regularly.

Now, if you think a little more deeply about our oil future scenario, you might wonder what happens if the refiner wants to buy at a different time than the well operator wants to sell, or in a different quantity.  Clearly there’s no guarantee that the two parties’ desires will match up exactly.  Who then are they to do business with?  If you’ve been reading this blog attentively, you know the answer: a speculator.  Just like the grocery store owner in my overworked example who buys green beans from a farmer without having a seller lined up, a speculator can go long oil thereby allowing the well operator holding the short side of the contract.  It’s then up to the speculator to find a buyer (or storage) for the oil.  But what if instead the refiner gets to the market first, and wants to buy oil that’s not for sale yet?  In that case the speculator’s role is to go short oil, in effect promising the refiner to find a source in time.  So in order to do his job, the speculator must be able to go both long and short.

In derivatives markets where the thing being traded is a contract (as above), each contract always has a long an short side.  Put another way, the positions sum to zero.  If everyone closed out their positions there would be nothing left – no physical goods.  Derivatives markets make shorting easy and painless because otherwise they couldn’t work.

The opposite of a derivatives market is a “spot” market – a market for something tangible available right now.  The stock market is a spot market.  If you buy stock, you actually get the stock.  Spot markets complicate shorting because unlike the futures market buyers in a spot market expect delivery right now.  There’s no delay to allow everyone to settle up first.  What this means is that in order to short in a spot market, you must be able to borrow the thing you’re selling short.  And this borrowing may well have a cost of it’s own – there are plenty of people willing to loan you stock, but probably not anyone willing to loan it for free.  These borrowing arrangements can get complex – for example, the borrowed item is usually reclaimed in a short amount of time if the lender wants to sell.  One major function of a good broker is making sure that borrow is available in a wide variety of spot securities (stocks and bonds mostly) and that alternate sources can be found if the first lender wants their securities back all of a sudden.  Ideally the whole process is painlessly automated behind the scenes.

One thing to note is that unlike derivatives, spot markets do not require shorting for the market to function.  Since there is a built in supply of the good, shorting is not required to create it in the first place as it is with a derivative contract.  This means that frequently spot markets will have limitations on shorting, such as the rather lame uptick rule US stock markets used to have.

There’s more to be said about shorting, and I’ll come back to the topic several times in the future.  But I do want to give two words of caution now.  The first is that short positions frequently have unbounded risk – while the price of a good can typically only decline to zero, it can in theory increase to an arbitrarily high value.  This means that in theory a short position can produce infinite losses.  This needs to be taken into consideration when entering short positions.  Second, many traders once they get the ability to short fall in love with it.  Shorting is a valuable tool, but the basic fact of the matter is that over extended periods of time most goods increase in price.  Shorting bets against this mega-trend, and as such most very long-run short bets are losers.  Shorting is a specific tool for specific circumstances (which I will delve into in future posts) and shouldn’t be used just because you can.