What is short-selling and how does it work?
Short-selling goes against the traditional mantra of buying low and selling high. But it can be a useful tool, helping traders to find opportunity even when prices drop. Find out what short-selling means and how it works.
Edited June 7, 2020
What is short-selling?
Short-selling, also known as ‘shorting’ or going short’, is a trading strategy used to take advantage of markets that are falling in price. The traditional way to short-sell involves selling a borrowed asset in the hope that its price will go down and buying it back later for a profit.
Borrowing the asset comes at a cost, which is normally a small percentage of the asset’s price. However, you can also short-sell using leveraged derivatives, which enable you to speculate on the price movements of an underlying asset without taking ownership of it.
What makes short-selling different is that you would take the position only if you have a negative outlook on an asset’s performance. You most likely believe that there is no potential for price growth, and you think the market is entering a downswing. If you didn’t, you would take a long position. Then there’s hedging; short-selling can also help you to hedge against potential downward movements if you have a long position open.
When you trade with us, you can use derivatives known as rolling spot forex contracts to go long or short on over 80 major, minor and exotic currency pairs – either with the aim of generating a profit or to hedge your existing positions.
How to start shorting
To start shorting forex pairs using derivatives, follow these simple steps:
- Open an IG trading account: it only takes a few minutes to open an account. You can even do it on your smartphone
- Find an opportunity: we offer various tools, including updated news and trade ideas, to help you find what you’re looking for
- Place your trade: when you’re ready to trade, open your first position by selecting the forex pair you want to short and choosing ‘sell’ on the deal ticket
Ready to start short-selling? Open an account with IG.
How does short-selling work?
Short-selling works in two different ways, depending on how you want to trade. Traditional short-selling involves borrowing the underlying asset from a trading broker, immediately selling it at the current market price, and then buying it back at a later date to return to the lender. The alternative way to short sell is to speculate on price movements using leveraged derivatives.
Traditional short-selling comes with a few limitations. For instance, because you don’t own the assets that you are going to trade, you’ll need to find someone that’s willing to lend them to you. The second method – using leveraged derivatives – does not require the exchange of an underlying asset.
When trading with derivatives, you make an agreement with a trading broker to exchange the difference in price of a currency pair between the time the position is opened and when it is closed.
Example of short-selling forex using leveraged derivatives
Suppose GBP/USD is currently trading at 1.2860, but you think the price will go down. So, you decide to open a short position on one mini lot, which is equivalent to 10,000 units of the base currency – in this case pounds. Your total exposure would therefore be $12,860 (£10,000 x 1.2860). However, because you are trading via leverage, you only need to put down 5% of the trade value ($643) to open your position.
Three days later, the price of GBP/USD is 1.2810 and you decide to close your short position. This means you would make $50 in profit ([£10,000 x 1.2860] – [£10,000 x 1.2810]). If the price went up instead, you would have made a loss. For example, if the pair was trading at 1.3010, you would have lost $150 ([£10,000 x 1.2860] – [£10,000 x 1.3010]).
The main benefit of short-selling is that it increases the number of trading opportunities. The two most popular reasons for short-selling are speculation and hedging.
Short-selling to make a profit
Short-selling gives traders a whole new dimension of forex price movements to speculate on – as traders can make money even if the value of the FX pair drops in price. On the other hand, short-sellers are often blamed for causing or aggravating a downswing to make more profit.
Short-selling to hedge open positions
Hedging is another way to use short-selling. This is the practice of holding two positions at the same time to offset losses from one position with gains from another. With hedging, traders with a short position can protect against losses to a long position. For example, if a currency you hold is at a risk of a decline, you could use a short derivative position to offset the risk. While hedging your positions may not necessarily prevent a loss, it can lessen the impact.
But short-selling also has its disadvantages. There is higher exposure to losses if the currency pair’s price doesn’t behave as you expect. If the price increases, your losses could potentially be unlimited. And if this happens, a short squeeze can occur, which means short-sellers all try to cover their positions at once – pushing the price of the pair up even further and amplifying losses. This makes it important to have a risk management strategy in place.
Why short-selling is important for efficient markets
Short-selling is important for efficient markets because helps to ensure they are priced correctly through price discovery.
Shorting helps increase market liquidity, as thousands of people are short-selling on any given trading day. This means that it is much easier for a buyer to trade forex because there is a constant supply. Studies have shown that restrictions on short-selling lead to lower trading volumes, making short-selling integral to financial markets. Liquidity from short-selling also leads to a significant narrowing of spreads, which ultimately results in reduced costs for traders.
In order to get the most out of the forex market via short-selling, it’s important that you do extensive planning and have a solid strategy. We’ve put together a few tips to get you started.
- Do a complete technical analysis on the FX pair before you decide to go short
- Be mindful of your position size – the larger it is, the more risk is involved. However, if the position is very small, you might not make much of a profit if the market does move in your favor
- Set up trading alerts that will notify you when your chosen currency pair hits a certain level
Short-selling summed up
We’ve summarized a few key points to remember on short-selling below.
- With IG, you can go short using leverage, which means you only need a small percentage of the trade value to open your position
- If the underlying market price dips, you could make a profit. If the market price rises instead, you will make a loss
- It’s important to have the appropriate risk management tools in place to avoid big losses
- You can open a live IG trading account in just a few minutes and start shorting today
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This information has been prepared by IG, a trading name of IG US LLC. This material does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. You should not treat any opinion expressed in this material as a specific inducement to make any investment or follow any strategy, but only as an expression of opinion. This material does not consider your investment objectives, financial situation or needs and is not intended as recommendations appropriate for you. No representation or warranty is given as to the accuracy or completeness of the above information. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. Any research provided should be considered as promotional and was prepared in accordance with CFTC 1.71 and designed to promote the independence of investment research. See our Summary Conflicts Policy, available on our website.
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