Did you know that you can trade both bull and bear markets?
We all know how the story goes when prices rise:
You buy and hold an investment until it reaches a higher price and make a profit on the difference between the buying and selling price.
However, many traders don’t understand how bear markets, i.e. falling prices can be used to profitably trade.
What Does Short-Selling Mean?
The usual way of making a profit in financial markets has long been this: you buy a stock, wait for its price to rise and sell it later at a higher price. Your profit would be the difference between your buying and selling price. This is what most stock traders do, they’re looking for stocks that are undervalued, buy them and hope that the price will rise in the future.
However, did you know that you can also make a profit when prices fall?
Short-selling allows you exactly that.
Short-selling refers to the practice of borrowing financial instruments from your broker and selling them at the current market price, with the anticipation of lower prices in the future. Once the prices fall, a trader would buy the same instruments on the market and return the borrowed instruments to the lender (typically the trader’s broker.)
The trader would make a profit equal to the difference of the selling price (when prices are higher) and the buying price (when prices are lower.)
Here’s a graphic that explains how short-selling work.
Step 1: Naked short seller (“naked” because he doesn’t own the shorted instrument) sells the borrowed instrument to the market (the “buyer”) at the current market price.
Step 2: The short seller buys from the market (in this case, the “seller”) at a lower market price and closes his short-position, making a profit on the difference between the selling and buying price.
Unlike beginners, professional traders don’t hesitate to short-sell a financial instrument. If the analysis is correct, a trader can make money both in bull markets and bear markets, which is the main advantage of short-selling.
However, bear in mind that short-selling doesn’t come without risks. When buying a financial instrument, there’s theoretically a limited risk associated with the trade. The price of an instrument can only fall to zero, but the upside potential is basically unlimited.
Short-selling is different. Since a trader is profiting from falling prices, there’s a limited profit potential as prices can only fall as low as zero. On the other hand, risks are theoretically unlimited as the price can skyrocket. This is the main reason why beginner traders hesitate to short in the financial markets.
With the rising popularity of derivative trading and CFDs, a trader can nowadays short-sell on almost all financial markets. While we’ve focused on stocks in this introduction to explain the concept of short-selling, the same practice works on any other financial market.
Whether you’re trading stocks, currencies, commodities or stock indices, you can profit from falling prices on the markets.
How Do Forex Pairs Work?
There are eight major currencies on the Forex market which are heavily traded on a daily basis. Those are the US dollar, Canadian dollar, British pound, Swiss franc, euro, Japanese yen, Australian dollar and the New Zealand dollar.
However, to trade on the Forex market, traders are dealing with currency pairs and not with individual currencies, because the price of each currency is quoted in terms of a counter-currency.
The first currency in a currency pair is called the base currency and the second currency is called the counter-currency. A rising exchange rate signals any of the following scenarios:
- The base currency is appreciating or the counter-currency is depreciating in value
- Both the base currency is appreciating and the counter-currency depreciating in value
- Both currencies are appreciating, with the extent of appreciation being higher for the base currency
- Both currencies are depreciating, with the extent of depreciation being higher for the counter-currency
Read those four points as many times as needed until you fully understand this concept. You need to know what is going on with the base and counter-currencies of a pair when short-selling on the Forex market.
Currency indices can do a great job in determining what currency is appreciating and what is depreciating. For example, take a look at the Dollar index (DXY), which shows the value of the US dollar relative to a basket of six major currencies which have the largest share in the US trade balance.
The following chart shows the US dollar index on the daily timeframe. A bullish candle shows that the US dollar was outperforming most other major currencies that day, while a bearish candle shows a relatively weak greenback.
Finally, currency pairs are usually traded in lots. One lot represents 100,000 units of the base currency. For example, if you short one lot of EUR/USD, you’re basically borrowing €100,000 and selling them at the current market price by funding the position in the counter-value of US dollars.
Can You Short on Forex?
Shorting on Forex is perfectly possible and many traders do it on a regular basis. Unlike on the stock market, risks associated with shorting on Forex are relatively limited because of the inter-relation of currencies in a currency pair.
For an exchange rate to go through the roof, there needs to be dramatic changes in the current market environment.
Similarly, the downside potential of an exchange rate is also limited. It’s an interplay of the value of both currencies that determines the current exchange rate.
Ugly ducklings can throw spanners in the works
However, Black Swan events (unexpected events with severe and long-lasting impact) do happen from time to time on the Forex market and are a nightmare for traders.
Think about the unexpected removal of the EUR/CHF peg by the Swiss National Bank in 2015. The value of the Swiss franc soared by 30% in a matter of minutes. This led to dramatic losses to many market participants who were short on the franc.
Another good example is the Brexit vote in 2016. Investors who were short on the EUR/GBP pair either finished the day with high losses or blew their account completely.
Rollovers and financing
When shorting on the Forex market, you also need to be aware of the rollover and financing costs which can decrease your potential profits.
Since you’re shorting the one currency and funding the position with the other currency of a currency pair, you’ll have to pay interest payments on the shorted currency. That said, you will earn interest payments on the funding currency.
If the interest rate of the shorted currency is higher than that of the funding currency, you’ll incur interest costs equal to the difference in interest rates. And if the interest rate of the shorted currency is lower than that of the funding currency, you’ll earn the difference in interest rates.
In addition, if you’re shorting on leverage, your broker will charge you financing costs depending on the amount you’ve borrowed. Financing costs usually depend on the current interbank rates plus your broker’s markup.
Watch: Is Leverage Your Friend or Foe?
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Best Currencies to Short
How to determine which currencies to short and which not to?
It depends on the analysis you’re using to find trades on the market.
As you already know, the best currencies to short are those which have the highest chance of losing value in the coming period.
Currency pairs that have formed reversal chart patterns on the daily chart during uptrends could be good candidates to short. Popular reversal chart patterns include:
- Head and shoulders pattern
- Double tops
- Triple tops
- Rising wedges (during uptrends)
- Triangle breakouts
You can also short currency pairs that have formed continuation chart patterns during downtrends, such as bearish wedges and triangle and rectangle breakouts to the downside.
Fibonacci levels also offer an excellent opportunity to enter into a short position if the price rejects an important Fib level, signalling that a downtrend is about to continue. Rejections of the 61.8% and 38.2% Fib levels are often used to enter into a short position during a downtrend.
Some traders like to use fundamental analysis to find good candidates for shorting.
Currencies that have a high chance of a rate cut (for example, because of weak economic growth, rising unemployment levels or weak inflation) are good to short-sell. Capital flows to currencies which have the highest interest rates, causing low-yielding currencies to depreciate and high-yielding currencies to appreciate.
Finally, political and economic turmoil, especially in emerging market countries, often cause a depreciation of the domestic currency.
Best and Worst Time to Short the Market
Despite being the largest, most liquid and most traded market in the world, there are times at which you should stand on the sidelines.
To explain the best and worst times to short the market, let’s quickly go through the main Forex trading sessions and their liquidity.
The Forex market is an over-the-counter market that trades during trading sessions, which are basically large financial centres where the majority of the daily Forex transactions take place. It’s no wonder that the largest world economies also have the largest share in the daily trading turnover.
The main four Forex trading sessions are:
- New York
Recently, Singapore and Hong Kong have also become big players in the currency market.
The New York session, also called the US session, is a heavily traded session during which major US economic reports are published. After the London session, the New York session is the most liquid of all Forex trading sessions with a high number of buyers and sellers available for all major currencies.
When the New York session is at its peak, it’s safe to short-sell a currency pair.
The London session is the largest European session and the most liquid trading session of all. The geographic location of London, being in between east and west, allows traders from both the US and Asia to trade during the London open market hours. The few hours during which the New York and the London sessions overlap represent the most-liquid and most-traded hours of all.
During these hours, it’s safe to scalp and short-sell at the same time.
Sydney and Tokyo
Finally, the Sydney and Tokyo sessions are major Asian sessions that trade when London and New York close. Asian currencies, such as the Japanese yen, Australian dollar, and New Zealand dollar are heavily traded during those sessions.
This makes it relatively safe to short those currencies against other majors.
Liquidity is your friend
As you’ve noticed, we mentioned the term “liquidity” several times. If you’re a day trader or scalper, you should only trade and short-sell during periods of high liquidity. Avoid short-selling during these times:
- Low liquidity – Liquidity refers to the number of market participants who are ready to buy or sell a financial instrument. If there is a high number of buyers and sellers, the liquidity is high. Similarly, a small number of active market participants are a characteristic of low liquidity. Liquidity is important because it allows you to immediately open and close a position with a market participant who has the opposite market order. When you buy, someone else has to sell, and vice-versa. In times of low liquidity, spreads can widen significantly and slippage can eat up a hefty portion of your profits.
- Major economic announcements – Markets can become quite volatile during times of major economic announcements. If you’re a scalper or day trader, avoid short-selling during these times.
- Ahead of important political and economic events – Think about Brexit, the presidential elections and the European sovereign debt crisis. All these events and the associated headlines can send shockwaves through the markets.
How to Close a Short Position?
After you’ve opened a short position, you’ll eventually want to close it to lock in profits or limit losses.
Remember what we’ve said in the introduction about short-selling. A short-seller borrows a currency, sells it at the current market price, waits for the price to fall and buys the currency later at a lower price in order to return the loan.
So, after you sell a currency, you’ll have to buy it to close a short position. This can be done either to lock in profits or to cut losses if the trade starts to go against you. If the currency starts to rise, you’ll still have to buy it in order to return the loan, only that in this case you’ll pay more than what you sold the currency for and incur a loss.
If your trade is in profit, the best time to close a short position is in times of high liquidity. This will ensure a tight spread and allow you to find a buyer close to the current market price.
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