The real value in trading has always been the fact that traders can profit in both up and down markets. This has always been one of those ideas that people have a hard time wrapping their brains around. Even though I spent a good deal of time telling you that you can always find a bull market in forex, that’s not where I want you to stop looking for opportunities. I’ll let you in on a little secret. Gravity applies to the markets too. Prices always fall quicker than they rise. It’s a function of fear and panic. And, yes, you can profit from it. But before you think of me as some heartless trader preying upon fear, remember that trading and investing must have participants willing to sell. I’m not sure where this concept blipped off the radar, but it’s one that the general public doesn’t seem to get: For every buy there is a sell. The reason prices move higher or lower is based upon where the transaction takes place. However, there still must be a buyer and seller willing to do a deal in order for a trade to take place.
Let’s discuss it in terms that most people can visualize, the housing market. When a house goes up for sale you have a seller, that’s the current homeowner. This homeowner is hoping that there is demand—and lots of it! More demand for the house, and the price at which they can sell (think of it as where the trade will be done at) will be higher. Less demand, and the price at which they will likely sell will be lower. The stock, futures, and forex markets work the same way. When there are plenty of homes for sale and not as many buyers, that’s a buyer’s market. If you were to plot that on a chart, the trend for home prices would be down. Now take that same scenario and apply it to a stock. Let’s use IBM. If IBM came out with a bad earnings report, or if a new product line flopped, or a problem was found in server design—any one of the myriad of issues that can hurt a company and a stock—the value of IBM would likely go lower over concern for what these issues mean to IBM sales and profits. What if you could profit from prices heading lower? We all know we can profit from prices moving higher as good news is discounting into a stock and both traders and investors buy in expectation of more success, profits, and sales from IBM. But what if events go the other way?
I’m going to warn you that you may need to reread this until you get the mechanics of what I am going to explain implanted in your mind. It may take some time to click, but once it does, it’s going to open a whole new world to you and your trading opportunities. I remember the first time I was introduced to the concept of shorting. It was foreign and took me a week to understand. Conceptually it made sense, but it wasn’t until I understood order flow that it made total sense. I began to see why it was such an important concept and a viable position to take in a downtrending market. Funny enough, I actually thought for a short while that it was illegal until my broker walked me through what I am about to explain to you. Remember that while you read this, until people are willing to sell and short the market as we know it, it would not exist. I’m not trying to be dramatic, it’s just plain fact.
I could just say that when you are shorting a market (stocks, futures, or forex) you’re selling it at a higher price and buying it back at what you hope to be a lower price for a profit. But selling something you don’t own doesn’t necessarily make sense, does it? And for those of you who are already familiar with shorting, I am probably preaching to the choir, but come along for the ride here regardless. You may find out a few things about order flow you didn’t know before.
I am going to use a stock example again, because time and teaching literally thousands of traders has taught me that using this as a frame of reference seems to be one that most people feel comfortable with, and the mechanics apply to any market. Let’s take our old friend IBM again. Big Blue is heading lower, and as a trader you understand that one of your
options would be to take a short position in IBM with hopes that it will head lower still from your selling price. How, who, and why?
The how of shorting is basically a process by which your brokerage will allow you to borrow shares of IBM. So that’s where you get the stock to sell: You are getting it, borrowing it, from your broker! Next is taking these borrowed shares of IBM and selling them into the market. Who will buy it from you? The markets are divided into two groups, buyers and sellers, also known as the bid and ask, respectively. Buyers bid on a stock they want to buy and like all buyers they would like to pay as little as possible. The ask, or sellers, are on the other side. They own what the buyers want, and of course they would like to sell it for as high a price as they can get. How much they will get for it depends upon whether it’s a buyer’s or seller’s market, just like real estate.
Imagine two lines of traders, one of buyers and one of sellers. These two groups are lined up by placing the bidder or buyer who is willing to pay the most for IBM at the front of the “buyer’s line” and the seller who is willing to sell for the least amount at the front of the “seller’s line.” The difference between the highest bid and the lowest ask is the spread. Starting to make sense?
At the front of each line are the two participants that are closest to being able to get a deal done. So who gets their price? Well, that’s determined by the overall direction of the market. The seller will have the advantage if prices are heading higher (more demand) while the buyer will have the advantage if prices are heading lower (more supply). In the trading world this balance can go back and forth from moment to moment. Since we are talking about shorting, we’ll assume that the overall market psychology is bearish. This means that the overall direction of the market is heading lower and that the buyers are able to have their way, which means that the trades are generally being done at lower prices.
So since you are shorting and you have your borrowed shares of IBM, you are on the ask or “seller’s line.” You have a price that you would like to sell these shares for, and your hope is that you can find a buyer and that prices will head lower after you sell your shares.
So how do you profit from such a position, and why would anyone buy it from you? The first part is easy. Since you borrowed the shares from your broker, all the broker expects is that you return the shares to them. It’s much like borrowing a book from the library. The library made you get a card so you are “approved” to borrow a book, and they expect you to return it. The broker in this case is typically going to let you have those shares borrowed out for pretty much as long as you need them. When you sold IBM, you collected a certain price per share from the buyer knowing that at some point you are going to need to buy some IBM sooner or later to return what you borrowed. Let me say that again, because here is often where the wheels fall off the wagon for a lot of folks.
You sold your borrowed shares of IBM into the market, and the buyer of those shares gave you, for sake of keeping this simple, $100 per share. Now you have this $100 per share, and that’s half the equation here of this short position. Now based on your analysis you think that prices should head lower, and by golly, they do! $98 . . . $93 . . . $88 . . . $87 . . . $84 . . . until they level off at your target of $80. So you sold at $100 and prices sold off to $80—a $20 difference. Remember, your broker wants their shares back at some point, and you’ve decided today’s the day and $80 is the price. So you execute another order. Your first order was a SELL. Your second order is a BUY. This will allow you to realize the $20 profit and return the shares of IBM back to your broker, thus closing out your short position. You sold these shares at 100 and are buying them back at 80, so the difference is yours.
I had also mentioned the “Why?” Why would someone buy these shares from you? Well, that’s what is so wonderful about the markets. There are always going to be contrary opinions. Without them there would be no market. When I think I see a buying opportunity, there is someone out there who thinks that I am out of my mind and that there is a selling opportunity. Without both sides of the equation, buyers and sellers, there would be no market; there would be no investing, no trading, nothing! So next time you hear about someone shorting the market, remember, there had to be a buyer for that trade to be done and without both types of market participants there would be no liquidity. We’ll talk later about liquidity and how the forex is the most liquid market on the planet and why that’s so important to us as traders. For now though, I hope your mind is starting to see the opportunity in playing both sides of the market.
And by the way, my shorting example of IBM has nothing to do with anything happening in the market. I have been an investor in IBM for many years. It is the first stock I ever owned. My father, a proud IBMer, worked for them until the day he passed away.
Let’s discuss it in terms that most people can visualize, the housing market. When a house goes up for sale you have a seller, that’s the current homeowner. This homeowner is hoping that there is demand—and lots of it! More demand for the house, and the price at which they can sell (think of it as where the trade will be done at) will be higher. Less demand, and the price at which they will likely sell will be lower. The stock, futures, and forex markets work the same way. When there are plenty of homes for sale and not as many buyers, that’s a buyer’s market. If you were to plot that on a chart, the trend for home prices would be down. Now take that same scenario and apply it to a stock. Let’s use IBM. If IBM came out with a bad earnings report, or if a new product line flopped, or a problem was found in server design—any one of the myriad of issues that can hurt a company and a stock—the value of IBM would likely go lower over concern for what these issues mean to IBM sales and profits. What if you could profit from prices heading lower? We all know we can profit from prices moving higher as good news is discounting into a stock and both traders and investors buy in expectation of more success, profits, and sales from IBM. But what if events go the other way?
I’m going to warn you that you may need to reread this until you get the mechanics of what I am going to explain implanted in your mind. It may take some time to click, but once it does, it’s going to open a whole new world to you and your trading opportunities. I remember the first time I was introduced to the concept of shorting. It was foreign and took me a week to understand. Conceptually it made sense, but it wasn’t until I understood order flow that it made total sense. I began to see why it was such an important concept and a viable position to take in a downtrending market. Funny enough, I actually thought for a short while that it was illegal until my broker walked me through what I am about to explain to you. Remember that while you read this, until people are willing to sell and short the market as we know it, it would not exist. I’m not trying to be dramatic, it’s just plain fact.
I could just say that when you are shorting a market (stocks, futures, or forex) you’re selling it at a higher price and buying it back at what you hope to be a lower price for a profit. But selling something you don’t own doesn’t necessarily make sense, does it? And for those of you who are already familiar with shorting, I am probably preaching to the choir, but come along for the ride here regardless. You may find out a few things about order flow you didn’t know before.
I am going to use a stock example again, because time and teaching literally thousands of traders has taught me that using this as a frame of reference seems to be one that most people feel comfortable with, and the mechanics apply to any market. Let’s take our old friend IBM again. Big Blue is heading lower, and as a trader you understand that one of your
options would be to take a short position in IBM with hopes that it will head lower still from your selling price. How, who, and why?
The how of shorting is basically a process by which your brokerage will allow you to borrow shares of IBM. So that’s where you get the stock to sell: You are getting it, borrowing it, from your broker! Next is taking these borrowed shares of IBM and selling them into the market. Who will buy it from you? The markets are divided into two groups, buyers and sellers, also known as the bid and ask, respectively. Buyers bid on a stock they want to buy and like all buyers they would like to pay as little as possible. The ask, or sellers, are on the other side. They own what the buyers want, and of course they would like to sell it for as high a price as they can get. How much they will get for it depends upon whether it’s a buyer’s or seller’s market, just like real estate.
Imagine two lines of traders, one of buyers and one of sellers. These two groups are lined up by placing the bidder or buyer who is willing to pay the most for IBM at the front of the “buyer’s line” and the seller who is willing to sell for the least amount at the front of the “seller’s line.” The difference between the highest bid and the lowest ask is the spread. Starting to make sense?
At the front of each line are the two participants that are closest to being able to get a deal done. So who gets their price? Well, that’s determined by the overall direction of the market. The seller will have the advantage if prices are heading higher (more demand) while the buyer will have the advantage if prices are heading lower (more supply). In the trading world this balance can go back and forth from moment to moment. Since we are talking about shorting, we’ll assume that the overall market psychology is bearish. This means that the overall direction of the market is heading lower and that the buyers are able to have their way, which means that the trades are generally being done at lower prices.
So since you are shorting and you have your borrowed shares of IBM, you are on the ask or “seller’s line.” You have a price that you would like to sell these shares for, and your hope is that you can find a buyer and that prices will head lower after you sell your shares.
So how do you profit from such a position, and why would anyone buy it from you? The first part is easy. Since you borrowed the shares from your broker, all the broker expects is that you return the shares to them. It’s much like borrowing a book from the library. The library made you get a card so you are “approved” to borrow a book, and they expect you to return it. The broker in this case is typically going to let you have those shares borrowed out for pretty much as long as you need them. When you sold IBM, you collected a certain price per share from the buyer knowing that at some point you are going to need to buy some IBM sooner or later to return what you borrowed. Let me say that again, because here is often where the wheels fall off the wagon for a lot of folks.
You sold your borrowed shares of IBM into the market, and the buyer of those shares gave you, for sake of keeping this simple, $100 per share. Now you have this $100 per share, and that’s half the equation here of this short position. Now based on your analysis you think that prices should head lower, and by golly, they do! $98 . . . $93 . . . $88 . . . $87 . . . $84 . . . until they level off at your target of $80. So you sold at $100 and prices sold off to $80—a $20 difference. Remember, your broker wants their shares back at some point, and you’ve decided today’s the day and $80 is the price. So you execute another order. Your first order was a SELL. Your second order is a BUY. This will allow you to realize the $20 profit and return the shares of IBM back to your broker, thus closing out your short position. You sold these shares at 100 and are buying them back at 80, so the difference is yours.
I had also mentioned the “Why?” Why would someone buy these shares from you? Well, that’s what is so wonderful about the markets. There are always going to be contrary opinions. Without them there would be no market. When I think I see a buying opportunity, there is someone out there who thinks that I am out of my mind and that there is a selling opportunity. Without both sides of the equation, buyers and sellers, there would be no market; there would be no investing, no trading, nothing! So next time you hear about someone shorting the market, remember, there had to be a buyer for that trade to be done and without both types of market participants there would be no liquidity. We’ll talk later about liquidity and how the forex is the most liquid market on the planet and why that’s so important to us as traders. For now though, I hope your mind is starting to see the opportunity in playing both sides of the market.
And by the way, my shorting example of IBM has nothing to do with anything happening in the market. I have been an investor in IBM for many years. It is the first stock I ever owned. My father, a proud IBMer, worked for them until the day he passed away.
