In all financial markets, including the Forex(short for Foreign Exchange), you "go short" by shorting an equity or a currency when you believe it will fall in value. With a stock, what you're doing is borrowing shares you don't actually own and agreeing to pay for those shares at some time in the future. If the shares fall in value from the time you execute the short sale until you close it out (by buying the shares at the later and lower price), you'll make a profit equal to the difference in the two values.
When you go short in the Forex the general idea is the same—you're betting that a currency will fall in value. If it does, you make money. The biggest difference between a short sale in the stock market and going short on the Forex is that currencies are always paired; every Forex transaction involves a long position in one currency, a bet that its value will rise, and a short position in the other currency, a bet that its value will fall.
How Short Selling Currency Works
When you “go short" on the Forex, you are simply placing a sell order on a currency pair. In Forex trading, all currency pairs have a base currency and a quote currency. The quote will usually look something like this: USD/JPY = 100.00. The U.S. Dollar (USD) is the base currency and the Japanese Yen (JPY) is the quote currency. This quote shows that one U.S. Dollar equals 100 Japanese Yen. When you place a short trade on this currency pair, you are going short on the USD Dollar and, as a result, simultaneously going long on the Japanese Yen.
The Basic Idea Behind Shorting on the Forex
It may sound complicated at first, but the underlying idea is straightforward: you would make this trade if you believed that at some future time, $1 U.S. was going to be worth less than 100.00 Japanese Yen.
Another difference between shorting in the stock market and on the Forex is that unlike the stock market, going short on the Forex is as simple as placing your order. There are no special rules or requirements for going short on a currency pair.
Understand the General Risk of Going Short
If you're thinking about going short on the Forex, 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 (while still bad for your investment portfolio) would be watching the currency's value falling to zero.
But there is a limit to your loss on a long position as the value of a 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.
Limiting Your Risk
One way of limiting your downside risk is to put in stop-loss or limit orders on your short. A stop loss order simply 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 when the currency you're shorting falls to a value you designate, thus locking in your profit and eliminating future risk.
One Last Word of Warning
The maximum upside on a short trade is 100%. Naturally, that sounds great, but the downside of a short trade is infinite. As explained earlier, a trader going short is profiting on a decline, and there is relatively limited scope for downside compared to the upside.
The FX market provides a good deal more flexibility for short-sellers and other markets, but it's still important to note that selling short still needs to be combined with good risk management.
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