Shorting
When trading in most financial markets, one normally has the ability to go in one direction “buy” or “up”, the only other option available is to be out of the market.
For instance say you were looking at a particular share that you believed was a good investment, the correct strategy would be to buy the share. If the share (lets call it “ABC”, was trading at $10 per share and you wanted to invest $10,000, you would buy 1,000 shares at $10. If the price went up by 1% say to $10.10, then your holding would be now be worth $10,100 a profit of $100.
Now say you thought the ABC share was going to go down, what could you do? In simple terms, nothing! You need to wait on the sidelines and wait for the ABC share to reach a price where you believe it would start to go up again and then buy once more. But in general you cannot readily profit from a fall in the price of ABC.
This is true for most financial markets the ability to short (sell it without owning it) a share, commodity or instrument is non-existent or has severe limitations. In the FX or Foreign Exchange market this is not the case. You can readily profit from rising or falling prices just as easily. This is a huge advantage, for if we assume that 50% of the time a financial market is either rising or falling, that means that you can only potentially profit out of a market 50% of the time; i.e. only in times when the shares are rising.
The FX market works in a different way, since when you enter a trade in the Forex market you are not really buying anything you are merely exchanging one currency for another. This can best be explained with an example. Let’s say a businessman was looking to travel from New York to Frankfurt. He had $5,000 cash on him, but knowing that in Frankfurt the base currency is the Euro he wished to exchange his USD to EUR. At the local money changer he was told that the EUR/USD exchange rate was currently 1.3400. This means that he could get 3,731.34 EUR for his $5,000 calculated as follows: 5000/1.3400=3731.34. As we can see the business traveler simply swapped or exchanged his USD to EUR, or in simpler terms he sold USD and bought EUR.
Here we see that the businessman is simultaneously long (bought) EUR and short (sold) USD. Trading in the FX market works in exactly the same way; when someone enters a trade, his view on the market is that one currency will either strengthen or weaken relative to another.
If we take exactly the same trade as listed and instead of saying that the individual was a business traveler, we say that the individual is a Forex investor why would he enter the same deal above? The answer is simple because he believes that the EUR will strengthen relative to the dollar in the future. How much will it strengthen and how much in the future is part of the strategy of trading in Forex –. (Refer to Trading Tips for a more in depth discussion) From this example it can be shown how one can potentially profit from the FX market 100% of the time, going long and going short occur together, as soon as an investor buys one currency he sells the other, as soon as an investor sells one currency he buys another.
Exchange vs. OTC (Over The Counter)
As discussed above the FX, Forex or Foreign Exchange market refers to a market where currencies can be exchanged from one to another and back again.
The first question that comes to mind may be “Where does this exchange occur?” In other financial markets such as the equity or futures markets, all trading is done through a recognized bourse such as the NYSE –The New York Stock Exchange.
A client wishing to trade on a share that is listed in NYSE, would contact a recognized broker, open an account with him, deposit funds and then buy a particular share that is listed with the hope of selling that same share at a future date at a price that is higher then the one that he originally bought it for.
All trades are governed by the bourse. When the bourse is closed for the day, trading ceases, one must wait for the beginning of the new business day before he can trade once again.
Not so with the FX market. The FX market is essentially non-regulated by governments but rather by the market itself. Many different bodies offer foreign exchange services; these may include banks, brokers, money changes and so on.
The difference between all these groups are generally the terms needed to do business with them and the conditions offered. The one thing they all have in common is that the exchange is performed between two parties for example a client and his broker, and is known as an OTC or Over the Counter transaction.
Who Trades in Foreign Exchange?
Traders in foreign exchange can essentially be separated into two groups, hedgers and speculators. The Hedgers: These are groups that transact in foreign exchange for the delivery of real funds.
These groups include Governments, companies – exporters and importers as well as some investors that have foreign exchange exposures or risk. These groups will use the foreign exchange market for two purposes;
1.One to hedge (insure) themselves against detrimental movements in currency prices, and
2.For the actual purchase (in terms of importers) of foreign currency to pay for foreign goods or services or sale (in terms of exporters) of foreign currency for that was received by supplying foreign goods or services.
Hedgers are the core of all foreign exchange trading; however with the expansion of the market it only makes up approximately 15% of the actual foreign exchange market.
The Speculators: These are groups which range from banks, funds, corporations and individuals – they create artificial rate exposure without any intention of actually receiving the currencies bought or delivering the currencies sold, they are simply looking to profit from the natural fluctuations in the value of the currencies within the Forex market. It is estimated that approximately 85% of the market is speculative.
For every one dollar traded by a hedger there are six dollars traded by a speculator.
What is a Currency?
Currency refers to a monetary unit that is the principle method of exchange for goods and services used by a country. Most countries have their own currency.
In the Forex markets, each currency is given a three letter code in English. The following is a list of some of the World’s most traded currencies.
| EUR | The Euro – The official currency unit for the European Union. Includes the following 13 countries: Austria, Belgium, Finland France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Slovenia and Spain. |
| USD | The United States Dollar |
| JPY | The Japanese Yen |
| GBP | The Great British Pound, also known as the Sterling |
| CHF | The Swiss Franc |
| AUD | The Australian Dollar |
| CAD | The Canadian Dollar |
| DKK | The Danish Krone |
| HKD | The Hong Kong Dollar |
| HUK | The Hungarian Forint |
| MXN | The Mexican Peso |
| NOK | The Norwegian Krone |
| NZD | The New Zealand Dollar |
| PLN | The Polish Zloty |
| SEK | The Swedish Krone |
| SGD | The Singapore Dollar |
| TRY | The Turkish Lira |
| ZAR | The South African Rand |
The first seven currencies listed the EUR, USD, JPY, GBP, CHF, AUD and CAD are known as the majors as they represent the overwhelming percentage of all the total trades in foreign exchange. It is said that approximately 90% of all trades involves the USD as one of the currency pairs.
Other local currencies include:
| BHD | The Bahraini Dinar |
| CYP | The Cyprus Pound |
| INR | The Indian Rupee |
| JOD | The Jordanian Dinar |
| KWD | The Kuwaiti Dinar |
| LBP | The Lebanese Pound |
| LKR | The Sri Lanka Rupee |
| OMR | The Omani Riyal |
| PKR | The Pakistan Rupee |
| QAR | The Qatar Riyal |
| SAR | The Saudi Arabia Riyal |
| THB | The Thai Baht |
Not all currencies are allowed to be fully floated by their governments, and hence real FX trading is really performed against those currencies that have a full floating exchange rate mechanism – this means that the market determines the strength or weakness of a currency without or with minimum government intervention.
What is a Currency Pair or Instrument?
When currencies are traded one against another they are known as currency pairs or instruments and appear as the three letter currency code followed by a slash and another three letter currency code, the following are examples of the leading currency pairs:
| EUR/USD | The Euro against the US Dollar |
| USD/JPY | The US Dollar against the Japanese Yen |
| GBP/USD | The Great British Pound or Sterling against the US Dollar |
| USD/CHF | The US Dollar against the Swiss Franc |
| EUR/JPY | The Euro against the Japanese Yen |
| EUR/GBP | The Euro against the Great British Pound or Sterling |
| AUD/USD | The Australian Dollar against the US Dollar |
| USD/CAD | The United States Dollar against the Canadian Dollar |
| EUR/CHF | The Euro against the Swiss Franc |
| GBP/JPY | The Great British Pound or Sterling against the Japanese Yen |
The first currency listed before the slash is known as the major, primary, base or leading currency, for example when EUR/USD is listed the EUR (Euro) is known as the major currency.
The second currency listed after the slash is known as the secondary currency, for example when EUR/USD is listed the USD (United States Dollar) is known as the secondary currency.
