The conventional way which most people feel profit can be made on the Foreign Exchange Market (Forex), and mostly on all other markets is to hold an investment or a stock with the hope that the price will rise in the future so that it can be sold at a profit. In Forex, traders look for pairs that are undervalued and buy them with the expectation of an appreciation in the value at a later time.
However, are you aware that as a trader, you can also capitalize on the depreciation of the value of a currency pair and make a profit from it? That is what short selling is all about. Short selling is simply the act of borrowing financial instruments from your broker and selling them at the current market price with the expectation of lower prices at a later date.
At the point where the prices fall, a trader would then purchase the same instruments on the same markets at the lower price and return the borrowed instruments to the broker. The profit is made from the difference between the selling price when the prices were higher and the buying price at which the prices have been lowered.
How does short selling in Forex work?
The concept of short selling is the same in Forex except the procedures are different. Unlike in stocks where you have to borrow financial instruments, the case is different in Forex. Usually, when we trade on Forex, we buy more of the currency pair which we feel the exchange rate is going to increase later on. This is termed as ‘going long’ on the market. As we will strongly remember, we know that currencies are traded in pairs on the market, the first being the base currency and the other the counter or quote currency. So that means that as we buy more of a certain currency or go long on the base currency, we are also going short on the counter currency.
Hence, ‘going short’ means we are selling more of the base currency and buying more of the quote currency with the expectation that the value of the currency pair will weaken.
For example, let us consider the currency pair EUR/USD.
If we were to go short on the EUR/USD at $100,000 when the price was, let’s say at 1.29. If the price should move lower, what that means is that the trader would make a profit, excluding commissions and other fees. Let us imagine another example where as a trader, you expect or predict further declines in the price and do not wish to close the position? You can simply decide to close a part of your initial position and keep the other half on the market until you decide to close the entire position
Short selling on Forex is very easy as it involves no borrowing since the currencies are in pairs. So you can sell the base currency and buy the counter currency at the same time. Also, the two-sided transaction format in which the currency quotes are presented is very simplistic and easy to understand.
Short selling provides an opportunity for traders to make gains on the Forex market in an uncommon way. However, the risks associated with it need to be identified and how to curb them so that profits are maximized. Short selling forex comes with a higher risk as the losses to be made are unlimited. When going long, you are trading with the expectation that the value will go high. If things were to go south, there is a threshold for loss as the price cannot go below the zero level. However, if you are going short, the losses to be made are infinite as the Forex values can increase without limit.
However, this risk can be managed by putting in stop-loss orders or limit orders. A stop-loss order authorizes your broker to close your position if the shorted currency rises to a certain value, shielding you from more loss. A limit order, however, authorizes your broker to close out your short position if the shorted currency falls to an already designated value, chosen by you, thus ensuring your profit and terminating future risk.
Understanding this would make it easy for you to engage with the Forex market as you’d know how to take certain actions as a result of your prior knowledge of the market.