Should you long and short the same instrument?

So you think you’ve come up with something particularly clever.

Maybe it’s a devious investment scheme, maybe it’s a way to launder money. Maybe you just want to see if it can be done. Either way, you’ve decided to take both a short and long position on the same stock.

Is there any good reason to do this?

Mostly, no

Perhaps unsurprisingly, this is rarely an effective strategy.

Going long and short on the same instrument is usually like betting heads and tails on the same coin. Every gain results in offsetting losses. It’s the same with stocks. When the long position does well your short position suffers to the same degree. When the stock does poorly, it’s vice versa.

Want to know more about short selling?

And to cap it off, you wind up paying brokerage, margin and interest costs on the whole thing.

Shorting against the box

There is one generally recognized situation when holding short and long positions on the same stock can be profitable: shorting against the box.

Let’s say you have a long position in GameCorp. You expect that they’ll do well over the long run, but also expect some short-term troubles that will cause their stock price to fluctuate in the meantime. You could sell your long position to try and capitalize on a few quick shorts, but then you’d lose the long term investment. (Maybe you got in at a particularly good price, or maybe you just don’t want to pay brokerage fees and taxes.)

Instead, that’s when short selling a stock you already own might make some sense. It lets you hold on to a long-term investment, and stick to a financial plan measured in months or years, while at the same time profiting off of brief dips in the price.

Profiting off quick fluctuations is called scalping, and day traders love it.

Restrictions

But beware of the IRS and the SEC.

The government doesn’t like it when traders get too exotic with their deals. (Something about the occasional bad experience.) As a result, there are some pretty strict rules about getting creative.

Getting too creative can get costly…

The SEC defines shorting against the box as a short sale “where the seller actually owns the stock but does not want to close out the position.”

It isn’t illegal per se, but the SEC does want to limit it. As a result, there are numerous restrictions on short selling specifically targeted at traders who go long and short in the same instrument.

Does that mean don’t do it? Not necessarily. As discussed above, this can be an effective strategy for traders who believe that a long term trend will have short term (and potentially profitable) fluctuations. But, and we cannot stress this enough, it does mean that shorting against the box absolutely should only be done in consultation with a financial professional.

You don’t want to accidentally break the law.

The wash-sale rule

Finally, keep an eye out for the IRS’ wash-sale rule. This applies when a trader makes a trade for which he claims a loss, then within 30 days buys back that same stock.

In other words, if you short and long the same instrument, you’ll inevitably take a loss on the losing position. The IRS doesn’t allow you to claim that loss on your taxes.