The short position in the foreign exchange market is one of the two major types of positions that exist. The other one being the long position. But in this article we are going to mainly focus on the short position.
Shorting an asset in any market is simply the act of betting against it. It means you are not so sure about its short term to even long term future. And that you count on it to lose its value. Because of the position you have taken, the way you will make profits is when the asset eventually loses its worth and value.
But as usual, there is more to it. So let’s see exactly what a short position is and how you can benefit from taking this position in the forex market.
What Is a Short Position?
Trading in the forex market includes the speculations that you make on the price or value of foreign currencies, especially when they are in a pair.
So at the heart of forex trading is mainly speculating. And in this market you can either go long or short on a forex trading pair.
But the instruments in the foreign exchange market are not like other instruments in various other markets. So for instance, in a market such as the commodities market or even the real estate market, when you go either long or short, you are going long or short on one asset.
But as we said the story is different with the forex market. The special feature of this market is that the instruments that are traded are in pairs.
There is a currency set against another currency and the two of them make up a trading pair in the market.
So in this case, what does it mean to go short or to go long on a pair?
First let’s take a look at what a pair is made of. A currency pair is made of a base currency and a quote currency.
What Are Base and Quote Currencies?
So the forex market is made of tens and tens of different forex trading pairs. These pairs have two foreign currencies. The first one is known as the base currency and the second currency in the pair is known as the quote currency.
The way it works is that you always put these two currencies against one another. You compare and contrast their worth to see how they will compare in the future.
Of course in any pair the base currency or the first currency is the important one. It is the base after all. And the quote currency will merely tell you how much of it is needed to buy the base currency.
So for instance, even in a pair in the forex market that includes a currency pair and a commodity such as gold, which makes the pair XAU/USD, we have the same equation of base versus quote.
Similarly, in the pair XAU/USD the base is gold and the quote is the US dollar. So it is gold denominated in the US dollar.
So now you know exactly what a trading pair in forex is and how it works. Then we shall see what it means to short a pair.
Shorting a Trading Pair in Forex
Imagine you decide to take a short position in regard to a pair such as EUR/USD.
Which currency exactly are you betting against?
To simplify the answer for going short, and also for going long, always consider the base currency. It is named the base currency for a reason.
When you short a forex pair, it means you are betting against the base currency. In other words, you are selling the base currency in exchange for the second currency, which is the quote currency.
How Can You Short a Pair in Forex?
So far we have learned about the concept of shorting, speculating, currency pairs, base currency, and quote currency.
To recap, let’s reiterate that shorting is not simply selling. As we said, shorting is betting against an asset. So for instance when you short pair, you are betting against the value of the base currency. In other words, you are anticipating that its value will be driven down by any number of factors.
Therefore, through any calculations and analysis necessary you have come to the conclusion that the value of the base currency is going to deteriorate.
You can come to this conclusion by either using technical analysis and analyzing the recent price movements. Or by looking at the economic indicators that surround the base currency – otherwise known as fundamental analysis.
In any case, this is how you can short a forex pair.
But how exactly do you benefit from shorting a pair?
How to Gain Profits from Shorting a Forex Pair?
So you have shorted a trading pair in forex. How do you actually make profits from that?
Remember, the short position you have placed with your broker means that you are betting against the base currency and are indeed selling that to receive the quote currency.
Your order is filled and your position is successfully carried out. Your bet is finalized. Then what?
Supposing that you were right and the base currency lost value against the quote currency, now that you have more of the quote currency against the base currency, you can start buying the currency pair again – which is of course the same as buying the base currency with the quote currency.
But remember, you are coming out of your short position. And your bet against the base currency was right.
And now you can buy more currency pairs than before. This is exactly where the profits are.
The spread or difference between the value of your assets at first, in terms of how many units of the pair you owned, compared with the value of your assets now which are translated into a much higher number of the currency pair means you have profited from your short position.
The Best Short Trading Strategy
Shorting on its own, when viewed with a tunnel vision, does not seem like such a good strategy of trading to begin with.
But remember, the best strategy trading for taking a short position would also look at the big picture of how things will turn out in the end.
In the example we provided above, you shorted the base currency when you knew its value was dropping. But when things started picking up again, because you had already shorted it, now you had a chance to buy it back again. This time in higher quantities.
So big picture stuff. But there is more. Another important reason for taking a short position that you need to consider in your short trading strategy is that sometimes it is merely an approach to minimize risks and losses. So when the market is plummeting, you short your position to avoid further losses.
A short position is not merely a selling position. Equating shorting with selling would be an oversimplified approach to defining such an important position. When you take a short position you are in fact declaring to the market that the value of the asset in question is going to fall and you either hope to make a profit in the end through your short position or you wish to avoid losses.