Long and Short Positions: The Two Sides of One Agreement

A long position is bound to buy the reference asset at the agreed price on the agreed date. A short position is bound to sell it at that same price on that same date. Neither side may decline. At any settlement price the two payoffs are exact mirrors, so what one side gains the other loses to the rupee, and the pair always sums to nil.

Two words do an enormous amount of work in this subject, and both of them are misread on first contact. A reader meets long and hears somebody who thinks the price is going up. A reader meets short and hears somebody who thinks it is going down. Neither reading is what the words mean. The two words name which end of one obligation somebody is standing at, in the same flat way that buyer and seller name the two ends of a sale, and an account that lets them drift into opinions has quietly turned a contract into a forecast.

Everything worked here runs on one invented reference asset. Its price today is Rs 2,000.00/-, the money to buy it costs 6.50 per cent a year, and it pays nothing at all while it is held. The absence of a payout is not decoration: a referenced thing that paid something out during the holding period would change every figure below, and the reference asset used throughout pays nothing at any point.

One price sits underneath every number in this guide, and it is worked rather than asserted. The price for immediate delivery is Rs 2,000.00/-. Multiply that by 0.065, one year of financing at 6.50 per cent a year, and the product is Rs 130.00/-. Added to Rs 2,000.00/-, that makes Rs 2,130.00/-. The agreed price is exactly that sum: a price today plus the cost of holding the money for a year, and not a single element of anybody's view about where the reference asset is going. Both positions in this guide are struck at Rs 2,130.00/-, and both of them are struck at it on the same day.

Rs 2,000.00/- also appears twice in two different roles, and why the two agree is worth saying at the start rather than leaving it to look as though one figure was copied into the other. Rs 2,000.00/- is the spot price of one unit of the reference asset. One position here stands on exactly one unit of the reference asset, valued at today's price, so Rs 2,000.00/- is also the exposure that the margin arithmetic is struck on. Same number, two jobs, and they agree because the exposure is the unit priced at spot rather than because anything was rounded to match.

What is a long position bound to do?

A long position is bound to buy one unit of the reference asset at Rs 2,130.00/- on the agreed date. Read the verb again. The verb is the lesson. Bound. Not permitted to buy, not intending to buy, not expecting to want to buy. The long positionThe side of an agreement that is bound to buy the referenced thing at the agreed price on the agreed date. is the side of the agreement that has to hand over Rs 2,130.00/- and take one unit, and it has to do so whatever the reference asset happens to be worth on the day.

The worst case anybody would raise tests that. If the reference asset is quoted at Rs 1,600.00/- on the final date, the long position still pays Rs 2,130.00/-. The long position does not get to say that the price has moved and it would rather not now. No clause in the agreement lets it step aside. Nothing was bought that would carry such a permission, and nothing was paid at the start that could be treated as the cost of walking away. The obligation is complete from the moment the price is agreed.

Here is the everyday version, and it is worth holding on to because it removes the finance vocabulary entirely. A household running on one salary agrees in April with the shop down the road that in October it will take one sack of rice and pay a price the two of them settle in April. October arrives. Rice is cheaper in the market that week. The household agreed to the April price and still pays it, and October does not reopen the conversation. Nobody in that story has a view about rice. One side wanted the price settled early and the other side agreed to settle it.

The agreed priceThe price fixed today for a transaction that takes place on a stated later date. Once struck it does not move again. of Rs 2,130.00/- is fixed on the day the position is opened and never moves again. The reference asset is what moves. On the final date one number arrives, the settlement priceThe price of the referenced thing on the date the obligation falls due. It is the figure the agreed price is finally compared with., and it is compared with Rs 2,130.00/- exactly once. Everything in this guide is that single comparison, run in two directions.

What is a short position bound to do?

A short position is bound to sell one unit of the reference asset at Rs 2,130.00/- on the agreed date. Same verb, same weight. The short positionThe side of an agreement that is bound to sell the referenced thing at the agreed price on the agreed date. is bound, and if the reference asset is quoted at Rs 2,400.00/- on the day it still sells at Rs 2,130.00/-. It does not get to look at the market that morning and decide it would rather sell there instead. There is no clause in this arrangement that would let it.

Now the part readers find hardest, and it deserves its own sentence rather than a footnote. Taking the short side does not require holding the reference asset when the position is opened. Nothing is borrowed here, nothing is sold in the market today, and nothing has to be produced on the day the position is entered. The short side has to be able to perform on the final date, and being able to perform on a stated future date is exactly what the collateral arrangement and the party standing in the middle exist to make true. The collateral and the party in the middle were built for that reason and no other.

Borrowing the reference asset in order to sell it in the market for immediate delivery is a completely different arrangement, with different mechanics and a different set of obligations, and it is covered separately.

Notice the symmetry that has just appeared without anybody arranging it. One agreement, one price, two parties, and each of them bound in the opposite direction against the same figure. The symmetry is not a design flourish. The symmetry is the direct consequence of there being one agreed price rather than two. The two sides cannot both be right about Rs 2,130.00/-: there is only one Rs 2,130.00/- and each of them is standing at a different end of it.

How do the two payoffs compare at four settlement prices?

The two payoffs compare as mirrors, and the fastest way to believe that is to see both columns printed together rather than to be told it. Four settlement prices are worked below. The four prices carry no claim whatever about where the reference asset will go: they are four places to test an obligation, and no probability attaches to any of them. Two of them are prices the reference asset has already been quoted at above, one of them is the agreed price itself, and one is a price above it. That is the only reason they were chosen.

Every figure in the table is a payoffWhat a position produces at settlement, before anything paid to enter it is taken off. at settlement rather than a profitThe payoff after everything paid to get there has been taken off. The two words describe different quantities even when they land on the same figure.. On this particular arrangement the two coincide. Neither side paid the other anything to enter, so there is nothing to subtract. The coincidence is convenient and it is also a trap, and a reader who lets it slip past will treat the two words as synonyms.

Work one row rather than reading four. At a settlement price of Rs 1,600.00/-, the long position is bound to pay Rs 2,130.00/- for something quoted at Rs 1,600.00/-. Rs 1,600.00/- less Rs 2,130.00/- is minus Rs 530.00/-. The short position is bound to sell at Rs 2,130.00/- something quoted at Rs 1,600.00/-. Rs 2,130.00/- less Rs 1,600.00/- is plus Rs 530.00/-. The same two numbers, subtracted in opposite orders: a mirror is never anything more than that.

Draw the same fact as two lines rather than eight bars and something else becomes visible. The long payoff rises steadily as the settlement price rises, one rupee for one rupee. The short payoff falls at the same rate. The two lines cross at Rs 2,130.00/- and at no other price, and the crossing point is the agreed price rather than a prediction that the reference asset will arrive there. At every price to the left of the crossing the long position is below nil by exactly as much as the short position is above it, and to the right of the crossing the same statement holds with the sides swapped.

Why does the pair always sum to nil?

Because there is one agreed price and one settlement price, and the two positions compare the same two numbers in opposite directions. That is the entire reason. There is no second mechanism underneath it, no adjustment, no rounding convention that happens to work out. Subtraction run one way and then the other way produces two figures that add back to nothing, and that is as true at a settlement price of Rs 1,743.00/- as it is at the four prices in the table.

Put the four sums in front of yourself rather than taking the claim on trust. Minus Rs 530.00/- and plus Rs 530.00/- add to nil. Minus Rs 130.00/- and plus Rs 130.00/- add to nil. Nil and nil add to nil. Plus Rs 270.00/- and minus Rs 270.00/- add to nil. Four rows, four sums, and none of them needed anything the previous row did not have.

Now take the consequence. The consequence changes how the whole subject reads. No wealth is created inside this arrangement and none is destroyed. What happens on the final date is that an amount moves from one side to the other. A transfer is a very different object from an investment that grows, and a reader who blurs the two will misunderstand every derivative that follows. A business that grows produces something that was not there before. A forward agreement produces a transfer, and the size of the transfer is the gap between two prices.

The everyday version is a wedding contract for a hall. Two households agree in January on the hall price for a December wedding. Come December, the hall may be scarcer or cheaper than either of them thought in January. Whatever happens, the amount one household saved by fixing the price early is the same amount the hall did not collect, to the rupee. Between those two parties the arrangement produced no new value at all. The agreement moved an amount across, and it moved it because a price had been fixed early rather than because either party had been clever.

Slide it to the far left and the long payoff reaches minus Rs 530.00/- while the short reaches plus Rs 530.00/-. Slide it to the far right and the two swap. Stop anywhere in between and the third row is still nil. The pinned row is not a design choice. Nil is the only value that row can ever take, and the reason is that the two bars above it are built from the same subtraction run in opposite orders. Notice also what the two lines do at the exact left edge, where the settlement price is far below the agreed price: the long position is at its worst there, and it is at its worst for the same reason the short position is at its best.

Which word applies to each figure here?

Naming the four quantities is the part most treatments skip, and skipping it is how readers end up blurring four different quantities into one vague sense of money. Every figure in this subject says which of four things it is. A price is what is agreed or quoted. A premium is what is paid to acquire a position. A payoff is what a position produces at settlement, ignoring what was paid to get it. A profit is the payoff after everything paid to get there has been taken off.

No premium is paid anywhere in this arrangement, and that is part of the teaching rather than a technicality. Neither side bought its position from the other. Nothing changed hands between them on the day the price was agreed. The absence of a premium is why the payoff column and the profit column carry the same figures, and it is also why the two words have to be kept apart. On an instrument acquired for a premium, an arrangement covered separately, the two columns come apart immediately, and a reader who learned to treat the words as synonyms will read that instrument wrongly.

Quantities take the same discipline. A notionalThe quantity a contract is struck on, used to size the obligation. It is a multiplier rather than an amount that changes hands. says how much the obligation is struck on. An exposureThe value of the referenced thing that a position stands on. It is what a move in the reference asset is measured against. says what value of the reference asset the position stands on. Forty of these positions, each standing on one unit, give a notional of forty at Rs 2,130.00/-. Forty times Rs 2,130.00/- is Rs 85,200.00/-, and not one rupee of it has moved. The exposure that the collateral is struck on is forty units at Rs 2,000.00/-, or Rs 80,000.00/-. One position standing on one unit is a teaching simplification; what a real contract stands on is set by an authority named further down.

What does each side put up before the position is carried?

The same thing, and that answer surprises most readers on first hearing. On a cleared position both sides post initial marginCollateral posted before a position is carried. It is not a payment for the position and it is not a part payment of the agreed price. before anything is carried. On the invented figures used throughout, each side posts Rs 160.00/- against Rs 2,000.00/- of exposure, being 8.0 per cent of it. The 8.0 per cent used here is a teaching figure rather than a requirement anybody has set. The actual requirement is set by clearing corporations under the framework of the Securities and Exchange Board of India (SEBI) at sebi.gov.in; it differs by contract and by day, and it moves.

Ask the obvious question. Why would the side that is bound to sell have to post anything, when it is the side that gets paid at the end? Because that framing has already assumed an outcome. On the final date the party who ends up paying is decided by where the settlement price lands, and nobody knows that in advance. The party standing between the two sides is exposed to whichever side the price moves against, and since it cannot know which side that will be, it collects from both. Symmetric obligations, symmetric collateral, and no view about direction anywhere in the arrangement.

There is a household version of that logic too. If two neighbours ask a third person to hold the stakes of an agreement neither of them can walk away from, the third person does not ask which of them expects to lose. Holding from only one of them would leave a gap exactly where it is least wanted, so the third person holds something from both.

Does a long position hold the reference asset?

No, and this is the block that stops the commonest wrong picture in the subject. A long position does not hold the reference asset. The long position holds an obligation to buy the reference asset later at a fixed price. An obligation is a different thing from the asset itself, with a different amount of money committed and a different behaviour. The two get confused because both of them do better when the reference asset is quoted higher on the final date, and people reason backwards from that shared direction to a shared nature. The direction is shared. Nothing else is.

Make it concrete with the money. The money is where the difference is impossible to argue with. Somebody who has bought one unit of the reference asset paid Rs 2,000.00/- and that Rs 2,000.00/- is gone; what they have instead is the unit itself, and they can look at it, hold it and sell it whenever they choose. Somebody holding a long position has posted Rs 160.00/- of margin and stands on Rs 2,000.00/- of exposure. Posted margin and a purchase price are not two ways of saying one thing. Posted and gone are different words on purpose, and the gap between them is Rs 1,840.00/- of money that has not left.

Keep the reference asset in mind here as well. The reference asset pays nothing while it is held, so the person holding the unit collects nothing during the year that the long position misses out on. The absence of a payout makes the comparison clean. A referenced thing that did pay something out during the holding period would open a real difference between holding the asset and holding an obligation on it, and the reference asset used throughout pays nothing at all.

When does a one for one offset actually cancel?

At the final date, and this is the sentence most treatments leave out. One unit of the reference asset already bought at Rs 2,000.00/-, set alongside one short position struck at Rs 2,130.00/- and followed to the final date, behaves like this. At a settlement price of Rs 1,600.00/- the unit is down Rs 400.00/- against what was paid for it and the short position pays plus Rs 530.00/-, so the two together are plus Rs 130.00/-. At a settlement price of Rs 2,400.00/- the unit is up Rs 400.00/- and the short position pays minus Rs 270.00/-, so the two together are plus Rs 130.00/- again. Held to the final date, the pair produces the same figure whatever the settlement price is, and that figure is the carry.

Now say when that is true. The moment matters more than the arithmetic. With a year still to run, the two sides do not cancel one for one, and a flat line drawn without naming the moment teaches an equality that holds on exactly one day. Work it. Suppose the reference asset is quoted at Rs 1,920.00/- instead of Rs 2,000.00/-, a gap of Rs 80.00/- measured from a base of Rs 2,000.00/-. The price at which the same obligation would now be struck for a year ahead is Rs 1,920.00/- carried at 6.50 per cent a year: Rs 1,920.00/- times 0.065 is Rs 124.80/-, and Rs 1,920.00/- plus Rs 124.80/- is Rs 2,044.80/-. Against the original Rs 2,130.00/- that is a gap of Rs 85.20/-. The financing is applied to the new price as well as the old one, so the gap on the contract price is larger than the gap on the reference asset by Rs 5.20/-.

Read carefully what that Rs 85.20/- is and is not. The Rs 85.20/- is the gap between two stated prices, Rs 2,130.00/- and Rs 2,044.80/-, each of them a price for delivery a year after the date it was struck on. It is not a claim about cash sitting anywhere today. The point to carry off this section is procedural rather than numerical: whenever two things are said to offset, the question is at which moment, and if the answer is not the final date, the offset is over-complete rather than exact.

What does a position say about what somebody thinks?

Nothing reliable, and that is worth saying plainly rather than implying it. A short position may be held against a unit of the reference asset already bought, precisely so that the two move opposite ways and the pair produces a known figure at the end. The offset worked in the section above is exactly that arrangement, and the party holding it has not expressed any view about the reference asset at all. They have removed the question from their year rather than answered it.

A long position may sit against a commitment to buy the reference asset later at whatever it then costs. Somebody who has to acquire one unit in a year and would rather settle the price now than find out later is not predicting anything either. The buyer is fixing a number so that the rest of the planning can be done against it. The household fixing the price of a sack of rice in April was doing the same.

A position is an obligation, and an obligation is not an opinion. Reading somebody else's position as their view goes wrong in both directions. The reading goes wrong about the ones held as offsets, the quiet majority in most arrangements of this kind, and it goes wrong about the size of any view that does exist. Nobody outside can see what else that party holds.

Then the same point about the price. The price is where this error does the most damage. Rs 2,130.00/- is Rs 2,000.00/- carried at 6.50 per cent a year for one year, worked as Rs 2,000.00/- times 0.065 giving Rs 130.00/-, and it is a cost rather than anybody's view. It does not say the reference asset will rise 6.50 per cent, it does not say anybody thinks it will, and it does not carry a view about the reference asset at all. Read plainly, the agreed price says that buying the reference asset today at Rs 2,000.00/- and borrowing the money for a year at 6.50 per cent a year costs Rs 2,130.00/- by that date.

Which parts of this are set by an authority in India?

Several, and every one of them is a real requirement that a real position would have to meet. Each is set by the authority named inside its row, each of them differs by contract, and each of them moves. A written out copy of any one of them would not be merely out of date on the day it changed. A written out copy would be wrong, and wrong in the most convincing possible way. A specific number reads as more authoritative than a pointer to where the number lives.

How does somebody actually use this in the room?

Four habits, and each of them falls straight out of something above rather than being general advice about care. The four habits belong to somebody who reads these arrangements for a living: a treasurer in a manufacturing business, an analyst reading a set of accounts, a lender assessing a borrower who carries positions of this kind, or for that matter a household that has fixed a price early.

1. Write down which side is held, as an obligation, in a full sentenceNot long or short, terms that invite the opinion reading straight back in, but bound to buy one unit at Rs 2,130.00/- on the agreed date. The sentence takes five seconds longer to write and it makes two things impossible to forget: that there is no permission involved, and that there is a date on which this becomes real.
2. Compare exactly two numbers, and never threeThe agreed price and the settlement price. Today's spot price of Rs 2,000.00/- built the agreed price once and then stopped mattering to the payoff, so a third number in the comparison is where most arithmetic errors on this subject come from. An analyst who catches this catches the difference between minus Rs 130.00/- and a figure that includes the spot price twice.
3. Write the exposure and what is posted on the same line, alwaysRs 2,000.00/- of exposure and Rs 160.00/- posted, together. Either figure alone tells a different story. A lender reading a borrower who carries these positions does exactly this, and to a lender the live question is how quickly a balance has to be topped up rather than how large the exposure sounds.
4. Read the two sides as one arrangement before reporting eitherA loss on one side of one of these is somebody else's gain, to the rupee. A transfer is not the same event as value destroyed. Somebody reading a set of accounts that contains one side of such an arrangement is looking at half of something, and the other half is sitting in an account they cannot see. Saying so out loud is what stops a transfer being reported as a loss to the world.

Notice what none of those four habits is. None of them is a view about whether to hold one of these arrangements, on which side, or at what size. Every habit above is about reading the obligation accurately, and reading an obligation accurately is not a step towards taking one on.

What question does this arithmetic not answer?

A reader who has followed the mirror this far arrives at one more question, and it is a fair one: which side is the one to be on? The arithmetic above does not answer it. The question is a proper one, but an answer would need facts that no worked example carries, and an answer given without those facts is worse than a refusal.

Then the useful thing instead: name what would have to be known before anybody could answer it. First, what the position exists to do, in a sentence. An offset against something already held and a position taken on its own are different arrangements wearing the same name. Second, what is already held against the position. Third, what has been posted, and what would happen to that balance if the reference asset moved against the position. Fourth, what happens on the day the money actually moves. A party can be right about a settlement price and still be unable to carry the position to it.

The mirror holds no outcome, no track record, no probability and no distribution. No arithmetic on these two positions yields a figure for how often a settlement price lands above or below Rs 2,130.00/-. The obligation is exact and the frequency is unknown, and the two facts are different in kind.

And the last point, the one most worth carrying away. Understanding how an arrangement works is never a reason to enter one. Neither side is the better side to be on: the payoffs are mirrors, and there is nothing to rank.

The reference asset, its spot price of Rs 2,000.00/-, its financing rate of 6.50 per cent a year, the agreed price of Rs 2,130.00/-, the four settlement prices and the 8.0 per cent behind the Rs 160.00/- of initial margin are invented.
Educational material. Not advice on any investment, tax, budget or market position.