Long and Short Positions
With order types and trade mechanics in place, you can now look at the two fundamental positions an investor can take in a security, and the very different risk profiles each one carries.
Long Position
A long position means the investor owns the security:
- Profits when the price rises
- Maximum gain: Unlimited (the stock price can rise indefinitely)
- Maximum loss: Limited to the purchase price (the stock goes to zero)
- Can be held in a cash account or margin account
Short Position
A short position means the investor borrows and sells a security they do not own:
- Profits when the price falls
- Maximum gain: Limited to the sale price (the stock goes to zero; you keep the full proceeds)
- Maximum loss: Unlimited (the price can rise indefinitely)
- Requires a margin account (you cannot short sell in a cash account)
- The short seller must eventually buy back (cover) the shares to return them to the lender
How short selling works:
- Investor borrows shares from the broker-dealer
- Investor sells the borrowed shares at the current market price
- Investor waits for the price to fall
- Investor buys shares back at the lower price (covering the short)
- Investor returns the shares to the lender and keeps the difference as profit
Exam Tip: Gotchas
- Short selling has unlimited loss potential because there is no ceiling on how high a stock price can rise. This is the opposite of buying stock, where the maximum loss is 100% of your investment (the stock goes to zero). The exam frequently tests this distinction.
Covered vs. Naked (Uncovered) Positions
These terms describe whether an investor holds the underlying security to offset their risk:
| Position | Definition | Risk Level | Example |
|---|---|---|---|
| Covered | The investor owns the underlying security | Limited risk | Selling a call while owning the stock (covered call) |
| Naked (uncovered) | The investor does NOT own the underlying security | Potentially unlimited risk | Selling a call without owning the stock (naked call) |
- A covered call writer owns the stock, so if the buyer exercises the option, the writer simply delivers shares they already own
- A naked call writer does not own the stock, so if exercised, they must buy shares at market price (which could be much higher) to deliver
Exam Tip: Gotchas
- Covered positions limit risk; naked positions carry potentially unlimited risk. Covered call writers deliver shares they already own. Naked call writers must buy at whatever the market price is.
- The exam loves asking about unlimited vs. limited loss potential for naked positions.