Historically, short selling (also referred to as ‘shorting’ or ‘going short’) has been used in stock markets under negotiated contracts. However, it has spread to almost every financial instrument, and the forex market is no exception.

It’s a practice normally used by traders to hedge currency exposure or simply profit from forecasted analysis. To put it simply, short selling currency involves taking positions under the pretense of a bearish sentiment.

In this lesson, we’ll explore the basics of short selling forex and explain the steps involved. We’ll also give useful tips on suitable risk-management tools you may want to use throughout your trading journey.

What does short selling currencies involve?

The term ‘short selling’ often confuses many new traders. After all, how can we ‘sell’ something if we don’t own it?

As mentioned, this is a relationship that began in stock markets before forex trading came to be. Traders wanted to speculate on the price of a stock going down, and so created a fascinating mechanism by which they could do so. These types of traders may not own the stock they want to bet against; but likely, somebody else does.

Eventually, brokers began to see this as a potential opportunity. So, they started matching up clients that held the stock with other clients that wanted to sell it without owning it. And so, speculating on the price direction of a market came to be.

Taking a short position in forex involves understanding currency pairs, trading system functionality and risk management. Transactions in the forex market are handled differently to stocks, which means the process of short selling a currency pair is very different.

When you short sell a currency pair, you’re effectively selling the base currency and buying the quote currency with the expectation that the value of the of the currency pair will fall.

Each currency quote is provided as a ‘two-sided transaction’ as shown in the image below. This means that if you short sell GBP/EUR currency pair, you’re not only selling the pound sterling, but you’re also buying the euro.

Because of this, no ‘borrowing’ needs to take place to enable the trade. Plus, forex quotes are normally provided in an easy-to-read format that makes going short simpler.

So if you wanted to go short on EUR/USD, for instance, you’d click on the side of the quote that says ‘sell’ in your deal ticket (as shown in the image below), choose how much of the euro you want to ‘sell’ and place your trade.

Closing your forex position is as simple – you’d just need to ‘buy’ the same amount of currency units you ‘sold’ to exit the market.

If the currency pair costs less to buy than when you sold it, you’d end up with a profit (excluding commission and fees). On the other hand, buying the market when it’s priced higher than when you sold it would mean you’ve realized a loss – this in addition to commissions, fees and any other charges your broker may have applied.

You could also choose to close a partial portion of your trade. Let’s use an example to illustrate this.

However, it’s important to keep in mind that you won’t always make a profit on your trades. Let’s use the same example as above, where you opened a short position on EUR/USD worth $100,000.

If the currency pair’s value appreciates instead of falls as you’d anticipated, then you’d make a loss (provided you closed your position after the market had risen).

For example, say you experienced a $15,000 loss when the market moved against you – meaning your position would be worth $75,000. If you closed half of the trade size as before, you’d get back $37,500 (ignoring commissions, fees and other charges).

The other half of this would continue in the market until you decided to buy another $37,500 in EUR/USD to exit the market (provided no further losses were experienced).

Remember, you might also need to pay commissions, fees and/or other charges as set by your broker.

How to manage the risk of short selling currencies

Short selling forex carries high risk as there’s no maximum loss on a trade. On a long (buy) trade, the value of a currency can’t fall below zero. However, losses are unlimited on short trades as forex values can theoretically increase to infinity.

Some of the ways to mitigate this short selling risk are:

• Implement a stop-loss on your trades
• 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
• Use price alerts on trades to stay informed when you’re away from your platform

Managing the risk on your short trades is crucial if you want to trade successfully.