A long position is owning or holding securities or contracts. For example, an owner of 100 shares of Apple common stock is said to be "long the stock." Being long indicates an expectation of rising share/contract prices.

A short sale allows investors to profit from a decline in a security's price if they believe the security is overpriced. In this procedure an investor (the seller) borrows shares of stock from another investor (the lender) through a broker and sells the shares. The lender keeps the proceeds of the sale as collateral. Later, the investor (the short seller) must repurchase the shares in the market in order to return the shares that were borrowed (covering the short position) to the lender. If the stock price has fallen, the shares will be repurchased at a lower price than that at which they were initially sold, and the short seller reaps a profit equal to the drop in price times the number of shares sold short.

For options, to be long means you are the buyer of the option. To be short means you are the seller of the option. Since the put option contract holder (long) has the right to sell the underlying to the option writer, he or she is actually short the underlying instrument.

The profit in short selling is limited to the value of the security but the loss is theoretically unlimited. In practice, as the price of a security rises, the short seller will receive a margin call from the broker, demanding that the short seller either cover his short position (by purchasing the security) or provide additional cash in order to meet the margin requirement for the security (which effectively places a limit on the amount that can be lost).

Leveraged Positions

Margin transactions occur when investors who purchase stocks borrow part of the purchase price of the stock from their brokers and leave purchased stocks with the brokerage firm because the securities are used as collateral for the loan. The interest rate of the margin credit charged by the broker is typically 1.5% above the rate charged by the bank making the loan. The bank rate (the call money rate) is normally about 1% below the prime rate. The market value of the collateral stock minus the amount borrowed is called the investor's equity.

Investors can achieve greater upside potential, but they also expose themselves to greater downside risk. The leverage equals 1/margin%.

Buying stocks on margin increases the investment's financial risk and thus requires a higher rate of return.

• Percentage margin. The ratio of the net worth or "equity value" of the account to the market value of the securities.

• Maintenance margin. The required proportion of equity to the total value of the stock. It protects the broker if the stock price declines.

• Margin call. If the percentage margin falls below the maintenance margin, the broker issues a margin call requiring the investor to add new cash or securities to the margin account. If the investor fails to provide the required funds in time, the broker will sell the collateral stock to pay off the loan.

Example

Suppose an investor initially pays $6,000 toward the purchase of $10,000 worth of stock ($100 shares at $100 per share), borrowing the remaining from the broker. The maintenance margin is set at 30%. The initial percentage margin is 60%. If the price of the stock falls to $57.14, the value of his stock will be $5,714. Since the loan is $4,000, the percentage margin now is (5,714 - 4,000) / 5714 = 29.9%. The investor will get a margin call.

When investors acquire stock or other investments on margin, they are increasing the financial risk of the investment beyond the risk inherent in the security itself. They should increase their required rate of return accordingly.

Return on margin transaction = (change in investor's equity - interest - commission) / initial investor's equity.

Example

Suppose an investor is bullish (optimistic) on Microsoft stock, which is currently selling at $100 per share. The investor has $10,000 to invest and expects the stock to go up in price by 30% during the next year. Ignoring any dividends and commissions, the expected rate of return would thus be 30% if the investor spent only$10,000 to buy 100 shares.

What will happen if the investor borrows $10,000 from his broker and invests it in the stock (along with his own $10,000)? Assume the interest rate is 9% per year.

• If the stock goes up 30%, his 200 shares will be worth $26,000. Paying off $10,000 of principal and interest on the margin load leaves $15,100. The rate of return, therefore, will be ($15,100 - $10,000) / $10,000 = 51%. Good investment, huh?

• Borrowing to invest, however, magnifies the downside risk. Suppose the stock actually goes down by 30%: his 200 shares of stock are worth $14,000 now. After paying off $10,900 he is left with only $3,100. The result is a disastrous rate of return of -69%!

• If there is no change in the stock price, he will lose 9%, the cost of the loan.