Short Selling Currency Explained
Short selling currency involves taking positions under the pretence of a bearish sentiment. Short selling is used by traders to hedge currency exposure or simply to profit from forecasted analysis.
This article explores the basics of short selling forex, using the GBP/EUR currency pair as an example to explain the steps involved. It will also cover suitable risk management.
What does short selling currencies involve?
In the forex market, transactions are handled differently to stocks which means the process of short selling a currency pair is very different. Firstly, a currency pair involves a base currency and quote currency as seen in the image below.
How to short forex: GBP/EUR short selling example
Taking a short position in forex involves understanding currency pairs, trading system functionality and risk management.
First, each currency quote is provided as a ‘two-sided transaction’. This means that if you are selling the GBP/EUR currency pair, you are not only selling Pounds; but you are buying Euros. Because of this, no ‘borrowing,’ needs to take place to enable the short sale.
Want to sell the GBP/EUR?
Just click on the side of the quote that says ‘Sell.’ After you have sold, to close the position, you would want to ‘Buy,’ the same amount (if you end up buying at a lower price than where it was sold, you would end up with a profit). You could also choose to close a partial portion of your trade.
For example, let’s assume we initiated a short position for 1 contract and sold GBP/EUR when price was at 1.29.
If the price has moved lower, the trader could realise a profit on the trade. But let’s assume for a moment that our trader expected further declines and did not want to close the entire position. Rather, they wanted to close half of the position to cover the initial cost, while still retaining the ability to stay in the trade.
The trader that is short 1 contract GBP/EUR can then manually enter in 0.5, then click on the ‘Close’ button to begin the trade closing process – offsetting half of the short position that was previously held.
Our trader, at that point, would have realised the price difference on half of the trade from their 1.29 entry price to the lower price they were able to close on. The remainder of the trade would continue in the market until the trader decided to buy another 0.5 contract in GBP/EUR to ‘offset,’ the rest of the position.
How to manage the risk of short selling currencies
Short selling forex carries high risk as there is no maximum loss on a trade. Losses are unlimited, as forex values can theoretically increase to infinity. On a long (buy) trade, the value of a currency can never fall below zero which provides a maximum loss level.
Managing risk on accounts was a trait we discovered with successful traders. Fortunately, there are ways to mitigate this short selling risk:
- Position size
- Implement stop losses.
- Monitor key levels of support and resistance for entry/exit points.
- Stay up to date with the latest economic news and events for potential downside risk.
- Employ price alerts on trades is a good way to stay informed when you’re away from your platform.
Short selling forex is preferred for down trending markets, however careful consideration is required before trading as it brings extra risk even with a bearish outlook. It has been utilised by large institutions/traders as hedges, or by traders looking to trade descending markets. Risk management is essential for proper application, and the methods mentioned in this article should be given the utmost consideration as adverse movements in price can be detrimental.