As you may not know, the term “short selling” is sometimes confusing for many newbie traders, and even confusing for long-time traders. So, how do we explain that we can sell something if we don't actually own it?
What is short selling?
Short selling (also known as “shorting”, “selling short” or “going short”) refers to the sale of a security or financial instrument for which the seller has borrowed an “asset” to make a short sale.
The speculator believes that the price of the product he borrowed will decrease in the future, allowing himself to buy it back at a lower price to make a profit, and then return the borrowed asset. Profit is generated when there is a difference between the price at which the asset is sold short and the price at which it is bought, which represents the short seller's profit (or loss, as the case may be).
Understanding Short Selling
In the past, short selling was an advanced strategy that should only be done by expert traders and investors with long experience in the market. Because, this work is often used in the commodity market under the contract agreement; Only investors - large investment funds can initiate a short sale through this "Negotiable Contract".
However, in modern financial markets, short selling has spread to virtually every financial instrument, most commonly on the Forex market. Short selling is used by traders to hedge currency risk or simply to profit from bearish market analysis.
For the Forex market, trades are handled differently than stocks, which means that the process of shorting a currency pair is very different. When you sell a currency pair, you are selling the base currency and buying the quote currency with the expectation that the value of the currency pair will fall.
Short Selling Vs Buy The Market
Buying the market is rarely mentioned because it is a traditional way of buying a financial product or instrument and expecting the price to rise is a natural thing. In the traditional financial markets, the concept of buying the market is hardly discussed, it's a normal execution market.
However, the concept of buy the market is mentioned when you want to buy a financial instrument in large volume - larger than your initial capital (balance) and you have to go to the Exchange by borrowing leverage.
Unlike short selling, a speculator borrows leverage for the purpose of multiplying profits. The profit earned from short buying will be an unimaginable amount compared to the capital they put in (otherwise it will also lead to rapid losses).
To sell short, the security must first be borrowed on margin and then sold in the market, to be bought back at a later date.
Is Short Selling Ethical?
Short selling is perhaps one of the most misunderstood topics in the investment field. In fact, these people are often criticized as callous individuals solely for financial gain. They can at any cost without trusting the companies and ruined livelihoods of the above process. Worse, these people have been deemed unethical by some critics because they are betting on a slowing economy.
However, the reality is quite different. Short sellers keep the market running smoothly by providing liquidity and also play a role in limiting investors' over-excitability.
Excessive optimism often drives stocks up to lofty levels, especially at market peaks (case in point—dotcoms and technology stocks in the late 1990s, and on a lesser scale, commodity and energy stocks from 2003 to 2007). Short selling acts as a reality check that prevents stocks from being bid up to ridiculous heights during such times.
While some critics have argues that selling short is unethical because it is a bet against growth, most economists now recognize it as an important piece of a liquid and efficient market.
The practice of short selling is said to have gained more respect in recent years with the participation of hedge funds, quant funds and other institutional investors in the activity. The explosion of the devastating global Bullish and Bearish markets during the first decade of this millennium also increased the desire of investors to learn about Short-Selling as a hedge against risk. for investment portfolio.
This activity is essentially a risky one because it goes against the long-term uptrend of the market, but it is especially dangerous when the market is strong. Short sellers facing escalating losses in a relentless bull market are painfully reminded of the famous John Maynard Keynes adage: “The market can stay irrational longer than you.” can stay solvent”, which means that this market is sometimes crazier than you think.
Who Are Typical Short Sellers?
Hedge funds are one of the most active entities involved in shorting activity. Most hedge funds try to hedge market risk by selling short stocks or sectors that they consider overvalued.
Not to be confused with hedge funds, hedging involves taking an offsetting position in a security similar to another in order to limit the risk exposure in the initial position. Therefore, if somebody is long the market using options or futures contracts, they will naturally sell short the underlying security as a delta hedge.
Sophisticated investors are also involved in short selling, either to hedge market risk or simply for speculation. Speculators indeed account for a significant share of short activity.
Day traders are another key segment of the short side. Short selling is ideal for very short-term traders who have the wherewithal to keep a close eye on their trading positions, as well as the trading experience to make quick trading decisions.
A Forex Short Selling Example
Let's take the EUR/USD pair as an example. When trading currency pairs, if you buy the base currency, you also have to sell the quote currency and vice versa. This means that if you are selling EUR/USD, you are not only selling EUR, you are simultaneously buying USD. Therefore, there is no need to 'borrow' any assets to be able to short-sell.
To sell EUR/USD you just need to click on “Sell the Market”. Once you have sold, to close the position, you will 'Buy' with the same amount (if you end up buying at a lower price than the stated price). Sell, you will make a profit - excluding commissions and fees.) You can also choose to close a portion of your trade.
If the price drops, the trader can get a profit from the trade (excluding commissions and fees). However, if the price continues to fall and does not want to close the entire position. Instead, you want to close half of the position for a partial profit while keeping the rest of the trade.
A trader who sells 100,000 EUR/USD (Equivalent to 1 trade lot), can enter 50,000 (equivalent to 0.5lot) and close it manually. Then click the 'Close' button to start the process of closing the 50k trade - close half of the short position and continue the Trailing-Stop.
The rest of the trade will keep moving in the market until the speculator decides to buy another 50,000 in EUR/USD to 'cover' the rest of the position (close the remaining 0.5lot).
At the moment, short selling is a relatively advanced strategy best suited for seasoned investors or Traders who are familiar with the risks of Short-Selling and the rules that come with it.
However, for those who know how to use it effectively, short selling can be a powerful weapon. By using put options to hedge risk in a bear market or speculating on a decline in a currency or financial instrument because of immediate risks.
This job is preferred for down-trending markets, however careful consideration is required before trading as it carries higher risks even with the prospect of a future of a Bear market.