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.
- Going short in the forex market means you're betting that a currency will fall in value, and if it does, you make money.
- When you go short in the forex market, you don't have to borrow a certain amount of the currency you want to short—you simply place a sell order.
- If you're thinking about shorting a currency pair, you must keep risk in mind; put in stop-loss or limit orders on your short.
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.)
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.
Brokers may charge a set commission—perhaps $5—for each currency trade of a standard lot they carry out, or they may keep the difference between the bid price and the asking price for each trade.
If you're thinking about shorting a currency pair, you must keep risk in mind—in particular, the difference in risk between "going long" and "going short." If you were to go long on a currency, the worst-case scenario would be watching the currency's value falling to zero. While that bet would be bad for your investment portfolio, your loss would be limited, because the value of currency can't go lower than zero.
If you're shorting a currency, on the other hand, you're betting that it will fall when, in fact, the value could rise and keep rising. Theoretically, there's no limit to how far the value could rise and, consequently, there's no limit to how much money you could lose.
One way of curtailing your risk is to put in stop-loss or limit orders on your short. A stop-loss order instructs your broker to close out your position if the currency you're shorting rises to a certain value, protecting you from further loss. A limit order, on the other hand, instructs your broker to close out your short position when the currency you're shorting falls to a value you designate, thus locking in your profit and eliminating future risk.