How to Bet on Falling Prices with Short Trading

How to Bet on Falling Prices with Short Trading

It is the desire of every trader to trade successfully. It doesn't matter if the prices are just moving upwards or if there is a red sign on the price boards.

The markets are always on the move and traders want to take advantage of these fluctuations. To profit from rising chart prices, they make a purchase and hope to sell at a higher price at a later date.

But how can they realize profits on Forex when values fall? One way is to go short (short trading). In this article, we explain what short trading is, how short selling works, the risks involved, and the alternatives when investing.

What is Short Trading?

To answer this question, let's first look at how a trade works on the Exness web in 2022. No matter what currency you want to trade and what your goal is - a trade always starts with the placement of an order.

The order finds its way into the order book by being passed on via the broker. However, for an order to be executed and thus for the order to be processed, there must always be a counterparty.

Exness is prepared to execute the trade at the specified prices. Thus, there is always a broker ready to buy and sell each executed trade. However, this fact does not give us any information about what goal the respective side is pursuing.

One thing is certain: The Exness broker gets the acquired securities booked into his account, whereas the seller can have two different results after the trade:

1.     He has sold a stock position on the market to take profits or for reasons of risk minimization.

2.     In anticipation of falling prices, he has designed a trading scenario with the aim of profiting from the price drops. For this purpose, he has the option to sell short.

How Do Short Trades Work?

Let's take a practical example to answer this question. From the news, you as a trader have learned that Amazon (remember, this is an example) has issued a profit warning due to poor business.

Therefore, you assume that you could probably buy the company's shares at a cheaper price in the long-term and short-term on Forex.

However, you do not want to wait until the stock starts to rise again after a price decline to profit from the price gains then, but you want to generate profits already with the price decline.

To do this, you sell 100 Amazon shares in the first step without having them in your securities account. The transaction is only possible because your broker lends you the corresponding number of shares to sell.

With this transaction, you now profit directly from any further decline in the share price. However, from this point on you are obliged by your broker to balance your "negative" position at a later point in time by buying the corresponding number of shares.

This balancing is the second step in your trade and completes the process.

The Mathematical Formula of Short Trading

The mathematical chart behind a short trade is relatively simple. By default, online brokers always display net gains or losses in their trading platform.

The lower the repurchase value of your shares relative to your sale value, the more money you make. So, the lower the price of the stock you are shorting, the higher your potential profits.

The formula is:

(Selling Price - Buying Price) x Volume - Transaction Costs = Profit

The individual factors of the formula can be explained as follows:

●      Selling Price: The price at which the trader sells the stock.

●      Purchase Price: The price at which the trader buys back the sold shares.

●      Volume: The number of shares (or other underlying assets) that the trader sells.

●      Transaction Costs: Commissions due at the broker for the transactions.

If there is a minus sign behind the equal sign:

1.     Minus, the trader has made a net loss.

2.     Plus, the trader has made a net profit.

Short Trading Example

Let's assume a trader has taken a short position of 100 shares of the company ABC, at a price of $20 per share. After a certain time, the price drops to $10 and the trader decides to buy back the shares. The profit of the trade is $1,000, minus commission, and interest payments.

If we put the values into our formula, we get:

($20 - $10) x 100 = $1,000

However, what would happen if the share price were to rise after the trader opened his short position? Let's assume that the share price rises to $50, and the trader decides to cut his losses. In this case, his loss would be $3,000:

($20 - $50) x 100 = -$3,000

In addition to this fat loss, the trader has to pay a commission and interest on the borrowed shares.

As you can easily see here, the losses amount to more than 100% of the invested capital ($3,000 > $2,000). This is the big risk of short selling: Since there is no upper limit for a stock price, you can theoretically lose an infinite amount of money in the process.

This is what sometimes happens in a so-called short squeeze, which we will discuss in more detail later.

What Are Uncovered Short Trades?

From a purely technical point of view, with every short trade, we enter a commitment to close the position later by buying it.

In the case of a covered short trade, the broker lends the trader the appropriate number of shares for the short sale from its inventory.

In this case, the trader must also buy back the shares at some point, but he knows in advance exactly that he will be offered them for purchase by his broker.

When opening an uncovered short position, the trader must buy back his position through the stock exchange or over-the-counter trading. Thus, in addition to the price risk, there is the risk that the trader will not be able to purchase shares to close out the position.