When trading, a forex trader will buy or sell or, to put it in the jargon, will go long or short on a determined underlying, which for the foreign exchange market will be a currency pair.
With this lesson we will focus on both operations.
The Buy Long operation
The purchase of an underlying is a very easy and intuitive transaction.
Buying EUR / USD or going long on EUR / USD means buying that currency exchange.
In the reality, in the currency market to buy EUR / USD means specifically buy Euros and sell Dollars, so, as they say in the jargon, be long on the Euro and short on the Dollar.
Ultimately, with a single operation you instead make two of them. In practice, however, the reasoning behind the mechanism is much easier if you imagine the transaction of purchasing EUR / USD as the purchase of any common underlying. Once you have purchased the underlying, in order to gain you just have to hope that the quotation, that is the market price, goes up, so you can resell your underlying asset at a price higher than that at which you bought it.
So, if you buy EUR / USD at a price of 1.3350, and the price would go up at 1.3400, you would have gained 50 pips when selling it. Then, we know that the value of the pips varies in function of the Lot Size used for the transaction.
If, however, after the purchase of EUR / USD at a price of 1.3350, the price had dropped to 1.3300, buy selling it on the market you would have lost 50 pips.
Let’s make a very practical example, that for the buying operation is not very useful, because I think you have easily understood it, but that will come in handy shortly for the comparison on the sell/short paragraph.
Let’s say that you have a shop of home appliances. Your goal will be to buy the goods at a lower price than that at which you will sell them.
You bought a washing machine for 300 euro, knowing that you can resell it at 550 Euros, making money on the difference. If everything goes smoothly and there are no unforeseen circumstances, you’ll be able to sell it at that price and you will get your profit, with the simple logic behind the purchase transactions.
Buy low, sell high.
If by chance, a few weeks after your purchase, the same washing machines brand or the competitor will present a clearly superior model, making yours looks obsolete, maybe you would find yourself having to sell your washing machine below cost, for example at 200 euro (cashing a loss of 100) in order to be able to find buyers on the market.
It is said that the buyer has a bullish view, ie he believes and hopes that the market price of what he has bought will go up.
The Sell Short operation
Let’s look at the opposite operation: the sell.
The sell is the other base operation for trading the forex market. The sale of the underlying is easy and intuitive if you already own the underlying. Quite simply, if you have the EUR / USD pair (because you have previously made a buy transaction), or the washing machine of the previous lesson, at some point you will decide to close your position by selling it. If you collect more than what you paid, then you will have a profit, otherwise a loss.
But this is a classic sale, it’s not the “short sell” that is made in Forex, which is the subject of this lesson. The short selling of the underlying transaction is less intuitive, but not so difficult. Sell short the EUR / USD or going short on EUR / USD means selling that currency pair.
The first question you’re probably making is, “How can I sell something I don’t have?“.
The reasoning behind the short sell is simple. You sell now to someone the EUR / USD pair at the price of 1.3350, in the hope that the price will drop to 1.3300, so to be able to buy it for those who you have already sold it and deliver it at the time of closing of the transaction, with the net gain of 50 pips.
If, once sold the EUR / USD at the price of 1.3350, the market price would go up to 1.3400, to close the transaction you should buy on the market at a higher price than what you previously sold, and you will take a loss of 50 pips.
To make things clearer, I’ll give you a more domestic example, and again I compare it to a dealer of home appliances.
Let’s say that in this case you still don’t have the washing machine in the store, and a housewife come to buy one. You let her see the catalog and she get convinced of brand and model. At that point you sell it, or you short sell it, because you do not have yet the washing machine. The lady pays for the washing machine 550 Euro.
Now what you need to do is go to your supplier and find that washing machine at a lower price than what you have sold it. If you will find at 300 euro, you will buy it and deliver it to the lady, profiting from the difference.
In the event that, after selling the machine to the lady at 550 €, there was a sudden increase in the value of the same, perhaps because of a particular news that had driven all the housewives to want that model, even the wholesale price probably would rise and you would not be able to find the washing machine from your suppliers for less than 600 Euros. In this case, in order to honor your contract, you should still buy it to deliver it to the lady, but in this case taking a loss.
It is said that those who sell short have a bearish view, ie they believes and hopes that the price will fall. Here you have explained the short selling operation.
We wanted to explain you what “Short selling” means because it’s a concepts that is often used in the finance and trading world, but always remember that in Forex, when you go Short on an exchange, you’re not short selling.
In Forex, when you are Short on a currency pair it means that you are buying the quote currency and selling the base currency, so we are always in the case of a normal transaction when you first purchase something and then sell it.