What is short selling?
Forex trading is a way of speculating on the future value of a currency pair.
Trading is buy low, sell high. For short selling, we do exactly that, but in reverse sequence, i.e. we sell high and then buy low. People have difficulty understanding how this works and end up asking the question “how can you sell something you don’t own?”.
I’ve several responses to that, so take your pick. The accurate answer is that we never own anything, it is pure speculation on the future value of something. By short selling, I am speculating the value will be lower at a future time and I make the commitment to buy it at that time. It is the way business runs. If you want to spend your profits from trading on a new car and that car is not in the dealer’s stock, it does not stop the dealer selling you the car.
They are expecting to buy the car for you at a later time. There is no guarantee they will be able to source the car at the exact same list price as they could today, so they too take on some risk. But the principle applies, sell first and buy it later, in effect, fulfilling the delivery. In the other video covering trading, “What is a Forex account”, you saw how dealing in currencies always involves selling and buying at the same time. Suppose I am trading Cable, and evidence suggests that the exchange rate is going to fall.
I can see the prices at which I can buy and sell this currency, buy at 1.5851 and sell at 1.5848. The price is fluid as the market is open as I take the trade. Suppose I were to go short on Cable, that means selling Cable at £8 per pip. Remember, a pip is the fourth decimal place on this currency pair. As I sell the currency, my position is shown along with the price I took the trade. My exit price is shown, which is the price I can currently buy at. A running profit and loss is shown too. Let’s watch this as the price changes.
Notice as the price increases, my P&L position has got worse. I have traded for a future value to be lower, so price rising is not what I want. I want the price to fall. Like that. But I am still losing money, as the spread of 3 pips has not been covered yet. Each pip of price movement is worth £8.00, as that was my initial stake. As the price continues to move in my favour, we reach break-even. It’s only 1 pip, but at least we’ve moved into profit. That’s better, 9 pips so far. Now up to 16 pips of profit. Up to 23 pips. This is my target on the trade, 25 pips. Let’s close the trade now, buying the currency at 1.5822 and bank £200 profit.
Let’s run through the trade. When I closed the trade, there was 25 pips of profit, the price having fallen in my favour as I’d sold the currency. This comes to £200 as my stake was £8 per pip. Had I staked £20, my profit would have been £500, 20 multiplied by 25. And so forth. It is possible to make losses using spread betting when prices move against you.
If the price had risen, my losses would have accrued at the same rate, so a 25 pip rise equates to a loss of £200. You need to understand risk management fully coupled with the use of stop losses. In this example, I used UK pounds to trade the British Pound and the US Dollar and did not have to do anything other than open and close the trade. The equivalent trade in a Forex account would involve selling a specific amount of currency.