Forex trading is the speculating on the future value of a currency pair. Forex traders can speculate on whether the value of a currency pair can go up or down. Generally, when traders feel the price is going to go down, traders short sell a currency pair.
When a trader sells a currency pair short, they anticipate that the value of the currency pair will depreciate in value in the near future. Short selling is a way to profit from falling prices in the market. As with all CFD trading, Forex trading is not all about buying low and selling high. With short selling, we sell high and then buy low.
Novice traders generally have a hard time grasping this concept. The most common question is how can someone sell something that you don’t own? In Forex trading, we never own anything because the trading is pure speculation on future value.
How Does Short Selling Work?
When you short sell, you speculate that the value of any financial instrument will be lower at a future time. When making the trade you make the commitment to buy it back at a specific time and price.
There are real-world examples of business operating this way too. If you want to buy a new car that is not stock, this doesn’t stop the dealer from selling you that car. They will let you buy the car for an agreed price, and buy the car for you at a later time.
There is no guarantee they will be able to deliver the car at the exact same price as they could today, so they take on some risk. This is the mechanism as we see in trading. Sell first and buy it later, in effect, fulfilling the delivery.
Short Selling the Forex Market
Trading in the Forex market always involves selling and buying currencies at the same time. The transactions are handled differently than in the stock market where it is purchase or sale of a single stock.
In the Forex market, the currencies are quoted in pairs. This means that if you try to sell the USD/ZAR pair, you are involved in two simultaneous transactions. On one hand, you’re selling US dollars and buying South African Rand a the same time. If you buy the EUR/USD currency pair, you’re buying Euros and selling US dollar at the same time.
Short selling in the Forex market is easy because a trader is provided with a two-way price quotation. The bid price is the price you can buy at, and the ask price is the price at which you can sell.
Short Selling Examples
Let’s assume that you believe gold price in the short term is going to fall. In our trade, we are going to profit from short selling gold. Where we open the short selling trade, and where we close the trade, determines our profit or loss on the trade.
In this example, we’re short-selling gold with the expectation that we can buy it back cheaper at a later time.
Let’s assume we initiate the short position at resistance level $1345. The market proves us right, and we now have the opportunity to realize a profit on the trade.
Short selling is a trading technique used to profit from downward trending markets. Short selling has been used as a hedging mechanism to protect the smart money against bearish movements in price. Like all trading activities, short selling has its own risks. Should the price dramatically rise you can lose all your original investment.