Short Selling Forex Tutorial | How Shorting Forex Works?

Forex trading refers to the financial activity of converting one currency into another. Currently, the forex market is the largest market in the world by trading volume. While a portion of currency demand in the market arises from actual needs, the majority of daily forex trading volume is dominated by trading activities.

The immense trading volume can lead to significant price fluctuations in some currencies, attracting a large number of investors to the forex market to buy and sell. Buying typically involves purchasing at a lower price and waiting for future price increases to gain profit, which is a common method in forex trading.

Besides this, there is also short selling. Next, I will discuss what forex short selling is and how to conduct a forex short selling trade.

What Is Forex Short Selling？

Short selling in forex trading is an investment strategy where investors anticipate that a currency's price will decline and trade based on that expectation. Unlike buying long, where investors buy a currency hoping its price will rise, short selling involves borrowing a currency from a broker and then selling it, aiming to repurchase it at a lower price in the future, thereby profiting from the price difference.

The purpose of short selling is to earn a profit from the price drop. If an investor correctly predicts the downtrend of a currency's price, they can buy back the currency at a lower price in the future and pocket the difference as profit. However, if the currency's price rises instead, the investor will incur losses.

Short selling can be profitable in both bear markets and short-term downturns. It can also be used to hedge against the downside risk of existing positions.

Forex Short Selling Strategy and Case Analysis

As shown below, the bullish forces in the market push the GBP/USD exchange rate up to point 1. At this point, investors start selling to take profits, causing the exchange rate to drop, forming the left shoulder. After a short-term decline, bullish investors who didn't buy earlier enter the market, pushing the exchange rate up to point 2, exceeding the previous point 1. Superficially, the market still appears optimistic, but short-term speculators sell to take profits again, causing the market to fall, forming the head of the head and shoulders pattern.

When the market drops to the previous low point, it rebounds again. However, investors lose interest, and the market turns down before reaching the high point of the head at point 2, forming the right shoulder. The formation of the head and shoulders pattern indicates that the market is likely to start declining. As shown in the diagram, the market falls to a new low at point 4. Thus, we can enter a short-selling trade at point 3 and take profit at point 4.

Best Time to Short Forex

Once you have mastered some forex short-selling strategies, to increase your trade success rate and profitability, you need to choose the right opportunities to enter the market. The following time periods are typically good opportunities to enter the market for trading:

National Unrest

The economic condition of a country is a crucial factor affecting exchange rate fluctuations. When a country's economy is growing rapidly, the demand for its currency increases, leading to currency appreciation.

Conversely, when economic growth slows, the demand for the currency decreases, leading to depreciation. Sudden outbreaks of war or the spread of global pandemics typically negatively impact a country's economic health, increasing the likelihood of future currency depreciation. Traders entering the market for short-selling during these times have a high probability of success.

Major News Releases

Significant news that impacts exchange rates usually includes political events and economic data releases. Investors' perceptions of a country's leaders influence their outlook on the country's future economic development, affecting currency demand.

Most investors closely follow political activities, such as national elections, which often cause significant forex market fluctuations and volatility. For instance, the 2016 Brexit referendum impacted the EUR/GBP exchange rate.

Additionally, economic data falling short of expectations can also lead to currency depreciation. Investors entering the market after major news events may increase their short-selling trade success rate.

Central Bank Operations

Interest rates are a key tool for central banks in regulating monetary policy and significantly influence the forex market. When interest rates rise, investors earn higher interest income, increasing currency demand and strengthening the exchange rate.

Conversely, if the central bank lowers interest rates, investors receive less interest income, reducing currency demand and leading to currency depreciation.

For example, if the Federal Reserve plans to cut interest rates in September, the USD exchange rate would likely decrease, making it an opportune time for short-sellers to enter the market.

Pros & Cons of Short Selling

Risks of Forex Short Selling

Short selling carries greater risks compared to buying long because, theoretically, the potential gains from going long are unlimited, while the gains from short selling are limited, resulting in a poor risk-to-reward ratio.

Additionally, the market can experience short squeezes. During a short squeeze, if the market rebounds and prices start to rise, short sellers rush to buy back their positions to exit, creating a situation where demand temporarily exceeds supply. This rapid price increase triggers more short sellers to cover their positions, further driving up prices and exacerbating the squeeze.

Therefore, as market prices continue to rise, the increasing number of short sellers covering their positions can create an uncontrollable situation for short sellers.

How to Control Forex Short Selling Risks？

The most effective way to control the risk of forex short selling is through stop-loss orders. Since the potential losses from short selling are unlimited, it's crucial to set stop-loss levels before entering the market. Additionally, staying informed about daily economic news and being prepared for potential market-moving events is essential.

If you cannot monitor price changes continuously, consider using your trading platform's SMS alert feature to receive notifications when there are significant price movements. Furthermore, aligning your short-selling trades with the overall market trend is key; shorting in a downtrend generally has a higher success rate and relatively lower risk.

Conclusion

Overall, forex short selling provides investors with more trading opportunities, but it comes with significant risks alongside the potential for high returns. Investors need strong psychological resilience and market analysis skills when engaging in short selling. Making rational decisions and conducting thorough research are crucial for managing short-term risks effectively. Only through these means can investors achieve success in the challenging realm of forex trading.

FAQs

What is a short squeeze？

A short squeeze occurs when the price of an asset rises, causing short sellers to buy back the asset to cover their positions and stop further losses. This buying activity increases the demand and drives the asset's price even higher, forcing more short sellers to cover their positions, leading to a significant price surge.

How is forex short selling used for hedging？

Forex short selling can be used to hedge against currency risk. For example, if you currently have $100,000 and will need to buy GBP in the future, you might worry about the USD depreciating against the GBP, which would reduce the amount of GBP you can buy. To hedge this risk, you can short sell USD/GBP in the forex market. If the USD does depreciate against the GBP, the gains from your short position will offset the losses from the unfavorable exchange rate, effectively protecting you from the risk of a declining USD/GBP rate.

How does selling a short differ from buying a put？

The loss on a sell trade can be unlimited, while the maximum loss on a put trade is the premium the investor paid to buy the put.