What does it mean to go short on a currency?
Going short, or short-selling, means that you are betting against the market. In this scenario, you are selling an asset on the assumption that its price will fall, and the more the price falls, the greater your profit.
Going short is the opposite of going long, where you anticipate the market will rise and would open a buy position. Typically, traders open a short position in a bearish market, and they open a long position in a bullish market.
How does forex shorting work?
Shorting currencies is an inherent part of forex trading. This is because when you trade forex, you are going long on one currency while you are simultaneously selling another. As a result, when you trade forex pairs, you are actually making a bet that one currency in the pair will appreciate in value relative to the other, or vice versa.
If you went short on a currency pair, it means that you expect the base currency to weaken against the quote currency. All currency pairs have a base currency and a quote, with the cost of the pair being how much of the quote currency you would have to sell in order to buy one of the base.
In the image below, you would go short on the EUR/USD currency pair if you believed that the euro would depreciate relative to the dollar, meaning it would cost fewer dollars to buy one euro – perhaps $1.1000 instead of the current $1.2000.
In doing so, you would effectively be selling euros in the expectation that they would decrease in value over time.
You can go short on forex by trading using derivatives such as CFDs and spread bets. With these financial instruments, you will be quoted the price as a bid and an offer – or a sell and buy. For example, the price for EUR/USD could be $1.2345, and the bid could be $1.2335 and the offer $1.2355.
In this case, you would open a short position at the sell price of $1.2335 in the hope that the value of the pair will fall. If the price does fall, then you will have made a profit. However, going short carries a unique set of risks in that, theoretically, an asset’s price can rise indefinitely. That’s why it’s important to mitigate your exposure to risk with stops and limits which can reduce losses and lock in profits.
Short selling is a popular trading and investment method used to take advantage of falling market prices. It can be extremely lucrative if you get it right, but it does come with big risks. Discover what shorting a stock is and how to take your first short position.
Short selling is the common practice of opening a position in the expectation that a market is going to decline in value. Shorting is often associated with stocks, but you can short sell a range of assets – including forex, indices, and commodities.
In traditional investing, you’d take a long position, believing that the market is going to rise in price. Later, you’d close your position by selling the asset on and taking any profit. When you short sell, you’re taking the position that the market is going to fall in value. Later, you’d close your position by buying the asset back for a lower value and taking the difference as profit.
It is most commonly used as a means of speculating on market prices, enabling you to take advantage of bear markets and short-term declines. Short selling can also be used to hedge against the downside risk to a position you currently have.
Want to start short selling? Open an account with us to take your first position or practise shorting in a risk-free environment with a demo account.
What does shorting a stock mean?
Shorting a stock is the process of borrowing shares that you don’t own and selling them to another investor. The aim is to buy the shares back later and return them to your lender, pocketing the price difference. You would short a stock if you have a bearish position on the future of the company – either in the short term or over a longer timeframe.
How does short selling a stock work?
Short selling works by borrowing shares – usually from a broker or pension fund – and selling them immediately at the current market price. Later, you’d close your position once the market has fallen, buying the stock back and returning it to your broker for the new, lower market value. The difference between the initial price you sold the shares for and the price you bought them back to is your profit.
Learn how the stock market works.
Finding a broker willing to lend you stocks to short can be difficult, as they’re essentially taking on the risk that you’ll be correct and return their shares at a much lower value. This is why most brokers will charge you interest for as long as your position is open.
Short selling via a broker is often referred to as the traditional way to short a stock but thanks to the rise in derivatives trading, it’s no longer the most common.
When you short sell with derivatives – such as CFDs – you won’t need to borrow the shares before you take your position, as you’re just speculating on the underlying market price. You’d just need an account with a derivatives provider, and you could open a short position simply by selecting ‘sell’ in the platform.
As shorting via derivatives is a much simpler process, it’s become a popular choice for traders looking to take advantage of downward markets.
In all financial markets, including foreign exchange (forex), you sell short when you believe the value of what you're trading will fall. With a stock, what you're doing is selling borrowed shares you don't own and agreeing to return those shares sometime in the future. If the shares fall in value from the time you initiate the short sale until you close it out—by buying the shares later at the lower price—you'll make a profit equal to the difference in the two values.
Going short in the forex market follows the same general principle—you're betting that a currency will fall in value, and if it does, you make money—but it's a bit more complicated. That's because currencies are always paired: Every forex transaction involves a short position in one currency and a long position (a bet that the value will rise) in the other currency.
Placing a Sell Order
Another difference between shorting in the stock market and the forex market is that in the latter, you don't have to borrow a certain amount of the currency you want to short. Going short in forex is as simple as placing a sell order.
Parts of the Pair
All currency pairs have a base currency and a quote currency. The base currency comes first in the currency pair, and the quote currency comes second. So for the GBP/USD pairing, the British pound is the base currency, and the U.S. dollar is the quote currency.
Changes in price are measured in pips. For every currency but the Japanese yen, a pip is 0.0001 of the value of the quote currency. When the yen is the quote currency, a pip is 0.01 yen. (Brokers will sometimes give values out to one digit past the pip—one-tenth of a pip or a pipette.)1
Many currency transactions are carried out in the standard lot of 100,000 units of the base currency. They can also be done in mini lots of 10,000 units or micro-lots of 1,000 units.
Let's say the GBP/USD rate is 1.3452, which means 1 pound is valued at $1.3452. If you expect the value of the pound to fall against the dollar, you will sell the currency pair at that rate. If you bought the pair after the rate went to 1.3441, you would have made 11 pips.
The math to find the value of a pip in the quote currency for a standard lot of the base currency is 0.0001 (one pip) / 1.3452 (exchange rate of pair) x 100,000 (lot size) = $7.43. That means for your 11-pip gain you would have made 11 x $7.43 = $81.73, excluding the commission.
Short selling is an investment or trading strategy that speculates on the decline in a stock or other security's price. It is an advanced strategy that should only be undertaken by experienced traders and investors.
Traders may use short selling as speculation, and investors or portfolio managers may use it as a hedge against the downside risk of a long position in the same security or a related one. Speculation carries the possibility of substantial risk and is an advanced trading method. Hedging is a more common transaction involving placing an offsetting position to reduce risk exposure.
In short selling, a position is opened by borrowing shares of a stock or other asset that the investor believes will decrease in value. The investor then sells these borrowed shares to buyers willing to pay the market price. Before the borrowed shares must be returned, the trader is betting that the price will continue to decline and they can purchase them at a lower cost. The risk of loss on a short sale is theoretically unlimited since the price of any asset can climb to infinity.
Understanding Short Selling
With short selling, a seller opens a short position by borrowing shares, usually from a broker-dealer, hoping to buy them back for a profit if the price declines. Shares must be borrowed because you can sell shares that do not exist. To close a short position, a trader buys the shares back on the market—hopefully at a price less than what they borrowed the asset—and returns them to the lender or broker. Traders must account for any interest charged by the broker or commissions charged on trades.
To open a short position, a trader must have a margin account and will usually have to pay interest on the value of the borrowed shares while the position is open. Also, the Financial Industry Regulatory Authority, Inc. (FINRA), which enforces the rules and regulations governing registered brokers and broker-dealer firms in the United States, the New York Stock Exchange (NYSE), and the Federal Reserve have set minimum values for the amount that the margin account must maintain—known as the maintenance margin.1 If an investor's account value falls below the maintenance margin, more funds are required, or the position might be sold by the broker.
The process of locating shares that can be borrowed and returning them at the end of the trade is handled behind the scenes by the broker. Opening and closing the trade can be made through the regular trading platforms with most brokers. However, each broker will have qualifications the trading account must meet before they allow margin trading.
Why Sell Short?
The most common reasons for engaging in short selling are speculation and hedging. A speculator is making a pure price bet that it will decline in the future. If they are wrong, they will have to buy the shares back higher, at a loss. Because of the additional risks in short selling due to the use of margin, it is usually conducted over a smaller time horizon and is thus more likely to be an activity conducted for speculation.
People may also sell short in order to hedge a long position. For instance, if you own call options (which are long positions) you may want to sell short against that position to lock in profits. Or, if you want to limit downside losses without actually exiting a long stock position you can sell short in a stock that is closely related or highly correlated with it.
Example of Short Selling for a Profit
Imagine a trader who believes that XYZ stock—currently trading at $50—will decline in price in the next three months. They borrow 100 shares and sell them to another investor. The trader is now “short” 100 shares since they sold something that they did not own but had borrowed. The short sale was only made possible by borrowing the shares, which may not always be available if the stock is already heavily shorted by other traders.
A week later, the company whose shares were shorted reports dismal financial results for the quarter, and the stock falls to $40. The trader decides to close the short position and buys 100 shares for $40 on the open market to replace the borrowed shares. The trader’s profit on the short sale, excluding commissions and interest on the margin account, is $1,000: ($50 - $40 = $10 x 100 shares = $1,000).
Example of Short Selling for a Loss
Using the scenario above, let's now suppose the trader did not close out the short position at $40 but decided to leave it open to capitalize on a further price decline. However, a competitor swoops in to acquire the company with a takeover offer of $65 per share, and the stock soars. If the trader decides to close the short position at $65, the loss on the short sale would be $1,500: ($50 - $65 = negative $15 x 100 shares = $1,500 loss). Here, the trader had to buy back the shares at a significantly higher price to cover their position.
Example of Short Selling as a Hedge
Apart from speculation, short selling has another useful purpose—hedging—often perceived as the lower-risk and more respectable avatar of shorting. The primary objective of hedging is protection, as opposed to the pure profit motivation of speculation. Hedging is undertaken to protect gains or mitigate losses in a portfolio, but since it comes at a significant cost, the vast majority of retail investors do not consider it during normal times.
The costs of hedging are twofold. There’s the actual cost of putting on the hedge, such as the expenses associated with short sales, or the premiums paid for protective options contracts. Also, there’s the opportunity cost of capping the portfolio’s upside if markets continue to move higher. As a simple example, if 50% of a portfolio that has a close correlation with the S&P 500 index (S&P 500) is hedged, and the index moves up 15% over the next 12 months, the portfolio would only record approximately half of that gain or 7.5%.
Pros and Cons of Short Selling
Selling short can be costly if the seller guesses wrong about the price movement. A trader who has bought stock can only lose 100% of their outlay if the stock moves to zero.