Shorting Forex: Overview, How To & Tips

Short selling or going short is a strategy that involves taking a position against the market. Therefore, traders sell assets on the assumption that their prices will fall. In this scenario, the more prices fall, the bigger your potential trading opportunities.

Historically, going short was commonly used in the commodity markets primarily under negotiated contracts. However, this strategy has spread to other financial instruments in current financial markets with shorting in forex being the most prevalent. Traders use short selling to create trading opportunities from market forecast analysis or to hedge currency exposure.^[1]

Let’s explore the basics of shorting in forex, the steps involved, and risk management using the EUR/USD pair as an example.

Short Selling CFDs on Currencies

Many new traders are often confused by the term “short selling” primarily because they don’t understand the concept of selling something you don’t own.

This relationship started in the stock markets long before forex was introduced in the financial markets. Traders came up with a mechanism that allows them to speculate on the downward movement of the price of a stock. Traders may not own the stocks they are betting against, but someone else ultimately does. Brokers exploit this opportunity to match clients that hold the stock, with clients that want to sell it without necessarily owning it.

It is essential to understand how transactions are handled in the forex market because the process of shorting a currency pair is handled differently from stocks.  A currency pair mainly involves a quote currency and base currency. Therefore, currency quotes are always provided as two-sided transactions. Short selling a currency pair is simply buying the quote currency and selling the base, expecting the value of the currency pair to fall.^[2]

How do you short a currency?

• Research to find a pair you would like to trade
• Carry out both fundamental and technical analysis on that pair
• Choose a trading strategy and understand your risk exposure
• Open a trading account
• Deposit funds
• Open and monitor your position
• Close your position

Researching which pair you would like to trade helps you understand the different pairs available, as well as their liquidity and volatility. These two factors are very important for traders who want to take bigger risks by opting for forex pairs with higher volatility, and for scalpers and other traders who want to create quick market opportunities by choosing pairs with more liquidity.

Shorting in Forex

Typically, traders open long positions in bullish positions, and short positions in bearish markets. Shorting currencies is an important part of forex because when you trade, you are essentially going long on a particular currency while simultaneously selling another. Therefore, trading forex pairs is actually betting that one currency will depreciate in value compared to the other, and vice versa.^[3]

Going short means that you are expecting the quote currency to gain value against the base currency. The cost of a currency pair is the amount of the quote currency that should be sold in order to purchase one of the base currency. 

Short selling in forex requires traders to understand currency pairs, risk management and trading system functionality. For instance, if you sell the EUR/USD currency pair, you are essentially selling Euros and buying dollars. Since you are shorting, ‘borrowing’ does not take place.

If you buy at a lower price than its previous selling price, you can earn a create trading opportunities. Moreover, you can choose to close part of your trade. Keep in mind that traders typically incur expenses such as commission and fees which eat into your actual returns.

For instance, let’s say we opened a short position for $50,000 when the price of EUR/USD was at 1.30. If the price moves lower, there is an opportunity for potential returns and vice versa. If we expect further decline, we may choose not to close the entire position, but instead close half the position while retaining the ability to stay in the trade.

Risk Management in Short Selling Currencies

Shorting in forex can be very risky because there’s no maximum loss on trades. Theoretically, forex prices can rise to infinity and losses are unlimited. On long (buy) trades, there’s a maximum loss level because the value of currencies cannot fall below zero.

How can you mitigate short selling risks?

• By implementing stop losses to lock in profits and reduce losses
• Staying up to date with the latest financial and economic events and news for potential downside risks
• Monitoring key levels of resistance and support for entry and exit points

Employing price alerts helps you stay informed even when you are away from your trading platform. Price alerts are email or mobile notifications that keep traders informed by alerting them when a specific market reaches certain price levels. Price alerts can be preset to suit the trader’s key levels.^[4]

The Bottom-line

Shorting forex can be done anytime, and usually during periods of downward trends. However, it is important to exercise due diligence before initiating trades as it carries significant risk even with a promising (bearish) outlook. Shorting forex is commonly used by large institutions as hedges, as well as traders looking to take advantage of descending markets.^[5]

Risk management for proper applications and trading strategies should be given utmost consideration because adverse price movements could have detrimental effects.

References

1. 4. 5. “Short Selling Forex: How to Short a Currency – My Trading Skills.” 24 May. 2019, https://mytradingskills.com/how-to-short-currency. Accessed 8 Apr. 2022.
2. “How to Short Forex: Short Selling Currency Explained – DailyFX.” 4 Feb. 2019, https://www.dailyfx.com/education/forex-trading-basics/how-to-short-forex.html. Accessed 8 Apr. 2022.
3. “How to Sell Short Currencies in the Forex Market – The Balance.” https://www.thebalance.com/what-it-means-to-go-short-in-investment-terms-1344960. Accessed 8 Apr. 2022.