The question is this: How can we sell something if we don’t own it?
Stocks short-selling can be defined as the practice to contact a broker to borrow financial instruments and sell them at the prevailing prices in the market when lower prices are expected in the future. The borrowed financial instruments can be returned to the broker by buying them from the market when their prices fall. The difference between the selling prices and buying prices will be your profit.
Forex short selling is the process of selling the base currency and buying the quote currency in the expectation that the value of the currency pair will fall. For example, GBP is the base currency, and I want to sell it. The USA economy is excellent, and in a rising trend, and the USD, the dollar is solid. GBPUSD is a currency pair that price will go down (my prediction, for example). So, forex’s short-selling of GBPUSD currency pair is when I SELL GBP base currency and BUY quote currency USD in the expectation that the value of the currency pair GBPUSD will fall.
How to short a currency in a market?
Technically, a seller sells base currency at the current market price and buys the quote currency. So, if a trader sells EURUSD, he sells EUR and buys USD. To short a currency you need:
- Sell base currency as a short seller at the current market price.
- Waits for the price to fall
- Buy quote currency to close the trade.
When you trade in the forex market, then you can do business not only in bull markets but also in bear markets. When prices increase in the forex market, people usually buy a currency and hold their investment until its price increases so that the difference in selling and buying prices can give them a profit. But most people do not know how to trade in the forex market when prices are falling. The information provided in this write-up will help you to know how to short forex trading.
How do you short the dollar, for example? I choose the strong currency in the market at that time—for example, CAD. Then, I SELL USD and BUY CAD to expect that the value of the currency pair USDCAD will fall.
Meaning of short forex trading
Normally, you can profit in the forex market by buying a currency and selling it afterward when its price rises. The difference in the selling and buying price of that currency will be your profit. So, for this reason, most of the forex traders look for undervalued stocks to invest in them with the hope of earning profits someday when its price rises.
But you can also earn profits when the price of that currency falls. It is called short-selling.
Working of short-selling
The investor who does not own financial instruments is known as a short seller. He borrows financial instruments from a forex broker and sells them in the market at their current price.
After some time, when the price of the same instruments falls in the market, then the short-seller buys them from the market at the prevailing price and returns to the borrower to close his short trading position. The disparity in the buying and selling prices will be the profit earned by the short seller.
Beginners and professional forex traders use the practice of short selling financial instruments. Forex trading in the bull and the bear market is the main advantage of forex traders that forex traders can earn profit in both market conditions by analyzing the market correctly.
Risks involved in short-selling in the financial markets
But, the short-sellers should also keep the risks of short-selling in their mind. The risk of trading the financial instruments you have bought can be the least as they have unlimited chances of increasing their prices, whereas their price cannot fall below zero. But in stocks short-selling, the chances of earning profits can be minimal as zero can be the last limit for falling the prices of short-selling instruments also but chances of increasing their prices can be unlimited. So you may not be able to earn any profit if the price of the short-sold instruments rises in the future.
Still, many traders in all the financial markets short-sell various financial instruments, including CFDs, currencies, stocks, and commodities these days to earn profits in the market with falling prices.
Working of forex pair trading
In the forex market, normally eight main currencies, including the Canadian dollar, US dollar, Swiss franc, British pound, Australian dollar, the dollar of New Zealand, Euro, and Japanese yen, are highly traded in routine. All these currencies are traded by forex traders in pairs instead of individually, as every currency’s price is determined based on the price of the counter-currency paired with it.
In these pairs, the first currency is the base currency, and the second one is the counter-currency. The rate of exchange of these currencies can rise if:
The value of base currency increases or that of counter-currency decreases the value of base currency increases along with a decrease in the value of counter-currency. The value of both the currencies increase with a higher increase in the value of the base currency value of both the currencies decreases with a higher decrease in the value of counter-currency
Currency pairs are traded in lots daily in the international forex market. To know the rising and falling prices of different currencies, you can follow the currency indices. Almost 100,000 units of the base currency are considered a lot to be traded in the forex market.
Many traders practice short-selling or shorting in forex because the shorting forex’s risk is much less than shorting stocks. After all, the prices of the currencies in a pair are interrelated.
The forex market environment changes dramatically when the exchange rate of the currencies in a pair increases or decreases highly as their exchange rate is determined based on both the currencies’ market values.
Risks of short forex
However, the forex market can become frightening for traders from time to time due to unexpected events. The unexpected removal of the pair of EUR/CHF in 2015 by the National Bank of Switzerland can be a good example to understand unexpected events in the forex market. This event has dramatically increased the value of the Swiss Franc by 30% within a few minutes. The traders short of Swiss francs have to bear huge losses.
The vote on Brexit in 2016 is another example of unexpected events in the forex market as many investors have to bear heavy losses which were short of the currency pair of EUR/GBP.
Costs on short forex
It would help if you also focused on the costs of rollover and financing when the forex market is on shorting as it can potentially decrease the profits of forex traders.
You will have to pay interest for funding one currency with the other currency in a pair if one of them is short. However, you can also earn interest in the currency you are funding depending upon the difference in currency pairs’ interest rates.
Moreover, you will have to pay the broker’s financing cost if you are short on leverage. This cost can depend upon the current rates of interbank transactions plus the markup of your broker.
Thus, it is how to short-sell in the forex market.