Short selling is an advanced strategy for traders who want to profit from bearish markets. It is also referred to as going short or shorting, and it is the act of selling an asset when its market price is falling or is predicted to fall, with the aim to buy it back at a lower price to make a profit.
How does short selling work?
Traders short an asset when they believe it is currently overvalued on the market and anticipate a drop in its price. In many cases, short sellers do not own the asset they want to sell and have to borrow it first, and this process of borrowing and selling is commonly taken care of by their broker. After selling, traders wait for its market price to fall and attempt to buy it back at a lower price so that they can return it to the lender. This is called short covering, and this type of transaction is referred to as a buy to cover. In a way, taking a short position in trading follows the same concept as taking a long position. In both scenarios, traders aim to make a profit based on the principle of buying low and selling high. The main difference between the two is the order in which the acts of buying and selling take place. In going long, traders buy first, when an asset price is about to increase, and then sell when it has risen to a certain level. In going short, the reverse happens.
Shorting currencies in the forex market
Short selling is a trading strategy that can be used in different financial markets, not limited to stock trading. In the context of forex, currency pairs can be shorted following the same principle. Generally speaking, all forex trades involve shorting currencies. This is because all forex trades involve a currency pair instead of just one currency. This means that it does not matter if a trader goes long or short on a currency pair—they will still be exchanging one currency for another, and to do this, they must still buy one currency and sell another at the same time. When a trader shorts a currency pair, they sell the base currency and buy the quote currency.
The risks of short selling
As with all acts of trading, there is risk involved. However, short selling is often described as an advanced trading strategy. This is because compared to a ‘traditional’ trader who goes long, a short seller can find themselves faced with the risk of losing much more money than they had invested in the first place, and they often have to monitor price movements closely and act quickly to prevent that.
Potential for unlimited losses
When ‘traditional’ traders go long with the anticipation that the price of an asset will increase, they only risk losing the amount of money they have invested. A trader who buys an asset at $50 will only lose a maximum of $50 should its market price begin to fall, because market prices will never fall below $0. As market prices have the potential to rise infinitely, this means that a trader who goes long will also, theoretically, be able to reap infinite profits. Prices can go up to $100, $150, or even $500. In these cases, the trader will be able to close their position with huge profits. However, the opposite is true for short sellers. When a short seller shorts an asset for $50, they are betting on its price to fall. As we learnt that market prices will never fall below $0, it means that the most they can make is $50. At the same time, in the case of the asset price rising to $150, $200, or even $500, they will still have to buy back the amount they had borrowed to return to the lender. In these cases, they will sustain huge losses.
Short sellers also face the risk of getting caught in a short squeeze. A short squeeze happens when there is excess demand for shares of an asset and a lack of supply. An asset that is speculated to fall in price can draw in a large number of short sellers. As many traders borrow shares of the asset and sell them, its price will decrease rapidly. However, this downtrend will not last forever, as borrowed shares must be returned at some point. This means that there will come a time when short sellers decide that the price has fallen low enough, and they can now close their positions and take profit by buying back the shares to return them. The first instances of short sellers buying back shares will cause an increase in the asset’s market price, which will act as a signal for other short sellers to start buying back shares too before the price rises higher and higher. This will trigger even more short sellers to close their positions and cut their losses, leading to a buying frenzy that will create an explosive increase in the asset’s market price. This is called a short squeeze, and it happens quickly. Short sellers who do not react in time will incur great losses.
Mitigating the risks of short selling
Although risks cannot be removed in trading, they can be managed. Traders, before making a short sale, are always advised to conduct sufficient market research. Additionally, short sellers can mitigate risks through using stop and limit orders. These are market orders placed by the short seller that can act as triggers to open and close positions when the price reaches a certain amount should market fluctuations go out of hand. Rakuten Securities Australia offers different types of stop and limit orders on our MT4 Trading Platform for ease of short selling, including Buy Stop, Sell Stop, Buy Limit, and Sell Limit.
The bottom line
Short selling is a way for traders to profit even when markets are going down, and a trader can utilise leveraged trading to increase the exposure of a short sale. Generally, a short seller runs a higher risk than a trader who takes a long position, as they are betting against price increases in markets that have the potential to rise infinitely. Therefore, traders should always do sufficient market research and ensure they have plenty of experience before attempting a short sale. Open a free demo account today to familiarise yourself with short selling strategies before placing real trades.