Definition of short

Spent the summer on a desk and did well, but was basically utterly confused. One example is 'short'. Is there a way to think of this word  to help me out here?

One trader sells something and says he shorted it, but he did have inventory--this trader said "short = sell". Another trader said short=I don't have the material but signed a contract anyway. So who is right/how do I approach this?

Another supposedly simple thing that keeps confusing me. One trader told me, "every time you do something in the market, you do the opposite to hedge it."   But he said nothing about expiration date/month. That's important, right? I then asked him if it's important whether your action on the futures market is to "close out" a hedge or to initiate a hedge (so based on my notes, if you previously did a long hedge, then when you physically buy the material you would 'short' the futures market to unwind your initial position--hence, "opposite" of the physical transaction), and he basically said it's not important--"just do the opposite". Was he just in a hurry or am I stupid?

 

Both those traders are right, if you are short that means you are in need of a material/will need to cover at some point (read short sale). If prices go down then you make money for your firm since you bought when prices are lower. Likewise long means I am more than covered so I make money if prices go up since I have locked in margin or I can sell on to somebody else and lose out if prices go down since I missed out on buying product cheaper or I sell on at a loss

Regarding hedges: this really should not be complicated. Say I am going to buy a product. I benefit on physical if prices go down but I want to cover if prices go up so what should I do in the futures market? Buy it and thus I am hedged! Expiration is important and in theory you want to have the hedge close as near as possible to the actual deal because you will have risk put on when you are out of the futures market. That said, you can form a view around the basis between different expiries.

 

Just to clarify - do you mean, you sold to a customer for something not yet priced (so it will price sometime in the future)? I assume if it's priced, then you can't really hedge right?

 
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I'm going to be careful here and only talk about power and natty (my areas). Let's walk through an example, customer wants fixed price NG for 202,1 market is $2, sales throws on $0.10 of margin, customer gets $2.10 fixed price for all of next year.  Once the deal is executed with the customer, the desk is now short gas at $2 (gas goes to customer).  To hedge, the trader will go out in the market and buy futures/swaps/basis swaps/etc. "to flatten" the position, i.e. go long--short physical gas + long financial gas = flat gas. As each month of 2021 rolls off, the market position gets converted into physical gas which then goes to the customer (folks who work in the biz, obvi I'm hand waving here in the sake of simplicity). 

If all the market stuff is confusing you, just think of it as you are Amazon; some products you have in your warehouse and can send to the customer right away; some you don't and need to find a third party supplier.  If you have it in your warehouse right now you are long that product and your sale is from inventory.  If you don't you are short the moment someone clicks buy and need to find the product in the market and deliver to customer at the agreed upon price.

 

In general, when a trader says they are short/long, does it always refer to the physical product, or is there no rule? For example if I buy something today with the intention of selling it, I am long physical. But to lock in the price, I sold the futures for x months expiry. So I am short on the financial side. I guess that was part of the confusion for me.

 

Yea not sure why I added that qualifier - shouldn't change the question anyhow.

 

While we're here, does anyone know anything about backpricing in physical markets? I've spent a long time thinking about one of the examples a trader gave me but couldn't figure it out. I tried asking him to explain again but it seems we're talking at different speeds...

The situation: We price 100 barrels in January and deliver it to customers in March. We also have the option of selling an additional 75 barrels in March at price levels in January, should we decide to exercise the option on March 1. The trader said that, we would hedge for the 100 barrels we are definitely selling, but not the 75 barrels. And if we decide to exercise the option because markets have fallen/bacckwardation, we would "buy 75 barrels paper and earn the spread." I've spent days thinking this over and drawing up examples but I just don't get why this spread gain ours to keep? We already have inventory to deliver the 75 extra barrels, which means this futures purchase was not used to lock in a purchase price. There was no previous short hedge, which means this purchase was not used to close out a futures transaction. If this futures is meant to be kept till a future expiry date, then there is no reason this P&L is ours to keep at this point in time. Someone please help...

 

Edit: Answered the above but I am realizing you are either getting us to do your case study for an interview or you might be facing some more fundamental issues. Perhaps I am giving myself too much credit, but after an internship I would definitely be comfortable with these concepts even if I have to game out the scenario in my head again. Nothing wrong with not being a trader; being a research analyst is fun imo.

If this is you mooching off of us for school work or an interview, please stop. Happy to answer this in a few days because I have a feeling you are simply getting us to give you straight answers

 

Yea, I won't blame you if you think that. I'm thinking of switching careers, none of it is coming together for me.

Regarding above situation though, I did try my best though I did not go into details. I cannot see how using January pricing in March, assuming prices have risen, is any different from using January pricing in January. Because the inventory costs were exactly the same? And if you just go into the futures market in March now to buy paper, you have to close that transaction eventually, no? So I don't see how that makes sense.

 

there are 2 different scenarios to think about when shorting, and while the economics of the position are almost identical.....the mechanisms are different

1) underlying security

2) futures contract

when shorting the underlying security (whether it be a barrel of crude oil, shares of stock, a bond, or whatever), yes, to short means to sell something that you don't own.  How does this work

1) you make the sale

2) you go find the item, and borrow it (typically, your firm will have a desk that only does this function...whether it be the stock loan desk for equities, or the repo desk for bonds)

3) you deliver the borrowed item to complete your "short sale"

Because you borrowed the physical item and are short it, you are paying daily interest on that borrow.

When you cover this short, you will buy the item in the open market, and then deliver that item to whoever you borrowed it from in the 1st place to deliver into your short sale.

The economics come from 2 items

1) the interest you pay to borrow the item, which fluctuates daily

2) the price difference between where you bought and sold the physical security

When you borrow the security (so you can deliver it into your short sale at the beginning of this process) you are not "buying it"..you are "borrowing it" and so there is no price involved in the borrow function.....as far as the original owner of the security cares, the security goes from A (owner) --> B (you)  --> A (back to the owner)  with no price attached...so no buy/sell economics involved in the borrow (just the interest rate on the borrow, which yes, is based on the underlying price).

Now, if we consider the futures market...its a little easier if we assume that you will not go thru with delivery.

Whether you go long or short, you are just making a bet of the price movement of the futures contract, which is based on the price of the underlying.  Yes, there are people who use the futures contracts to go thru with delivery...but the majority of trading in futures contracts is closed out flat before expiration so they do not go thru with delivery.

If you short the futures...you are just betting that the price will go down....and when you cover that short (via buying the same # of contracts) your position become flat (+/- your realized P&L in your account at the exchange)

if you hedge your position...that implies that you are buying a security that behaves similar to whatever you are short...but its not the EXACT SAME THING otherwise this would be a cover...not a hedge.

 

Thanks for writing that out. I went back to my notes again and I think I realize where my main confusion is. It's that the pricing month and the delivery months are different, which means there are two exposures. For example, if we sell the barrel in February but price it based on January, that means we are "short" in February because we need to go out into the market and physically buy a cargo in Feb for delivery. Hence, we are exposed to any price increase. However, in January when we price that eventual sale, we are "long" the price because, if the market rises, we benefit from it.

So for any given purchase or sale, there are actually two legs of exposure, unless the pricing and the physical transaction overlap. In that case, your exposure would theoretically be flat. Practically speaking however, you aren't necessarily so. For example, suppose we have the same scenario but this time the pricing date and sell date are both in February. In a theoretical world that means you go out to market, buy a cargo, and immediately sell it on. But you can't really do that can you, because there are transit times and such. So unless you had some prior inventory that is already on the water in January, you are still exposed to the short--even though the "pricing long" cancelled out the "physical short", you are still short UNLESS you can allocate prior inventory to it.

I know there's still a long way to go for me but I hope I'm at least getting closer/seeing more of the picture.

 

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