02 May 2008

Short Or Long?

Now that we know how to read risk graphs, we can clear up another area that is often confusing to the neophyte options trader, the principle of “long” and “short”.

For this purpose I’d like to separate out two concepts.

1/ Being long or short an instrument (share, future, option etc)
2/ Being long or short the market

This is going to seem blindingly obvious at first, but stick with me on this.

Share traders have uncomplicated mechanics with regards to being long or short. We’re all pretty comfortable with the concept of going long stock. When we are bullish on a market, we want to go long that market. We do this by going long, or buying stock. We are long the market and long the instrument (the stock).

Likewise, if we are bearish on a market, we want to go short on the market, we do this by short selling stock. So we are short the market and short the instrument.


The picture with options can become a bit more complicated. Ignoring two, and multi-legged positions, which we will be covering later, it is possible to be long and short at the same time and here is where our risk graphs can help us.

If you buy an option, you are long the instrument. Likewise if you write an option, you are short the instrument. But our market bias will be affected by whether the option is a put or call.

1/ Buy a $50 call with the underlying trading at $50.

This is the same sentiment as being long stock. As you can see we need the underlying market to rise in order to profit. You are long the call option and also long on the market.

2/ Buy a $50 put with the underlying trading at $50. (Assuming no accompanying stock position)

This is the same market sentiment as being short stock, we are bearish and short the market because we need the market to go down in order to profit. Yet we are long the instrument because we bought the put. So in this case, we are long the instrument, but short on the market.

3/ Write a $50 call with the underlying trading at $50.

Here is a case where we are short the instrument, because we have written, or sold the option. We are bearish because we really want the stock to go down so we are short the market as well. But if you look at the risk graph, the stock can actually go up a little bit to just under $52.50 and there will still be a profit at expiry. So in the case of a written call, we can be said to be short the call and short to neutral on the market.

4/ Write a $50 put with the underlying trading at $50.

Finally, the written put, a short the instrument position in the above risk graph is long to neutral on the market.

It’s important to get this concept firmly in your mind as confusion here can lead to execution errors, particularly if using an electronic platform.

In conclusion:

Next - Option Chains & Symbology

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