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Having done FX trading as a hobby for nearly two years now (and having made some profit overall), I now have got a fundamental question which I think I already have the answer to, but I would like to know for sure.

My question is if the risk for long positions is higher than for short positions or vice versa in FX trading. I am not talking about the risk which is caused by economic or political situations or changes, but about the amount of money I could loose if the market goes to the wrong direction.

I think I can't make my question clear without an example. Suppose the following situation:

  • I am trading EUR/USD.
  • My trading account currency (eventually the right term is home currency) is EUR.
  • I have 1,100,000 EUR available at my trading account.
  • My broker is a market maker.
  • The leverage is 1:1.
  • The spread is always 0.
  • The margin is always 0.
  • The rollover fee is always 0.
  • 1 EUR is worth exactly 1 USD when opening a position.

I know that these conditions are not realistic, but they will simplify the answer to my question drastically and help us concentrate on the crux of the matter.

Long EUR position ("buy")

Now I am opening a long position of 100,000 EUR. Technically, as far as I have understood, that means that I am taking a credit of 100,000 USD (exchange rate when opening is 1:1 as defined above) from my broker and immediately am exchanging that money to 100,000 EUR. Thus, I now have 100,000 EUR available at some virtual place, but I am owing my broker 100,000 USD.

Now lets assume that the exchange rate becomes 1 EUR = 0.1 USD (i.e. 10 EUR = 1 USD), i.e. the market changes in the wrong direction (from my point of view) by a factor of 10.

Then, when closing the position, I must give my broker his credit (100,000 USD) back. When doing so, I am first taking the 100,000 EUR from their virtual place, exchange them into USD and give them back to my broker. Since the exchange rate now is 1 EUR = 0.1 USD, I give my broker only 10,000 USD back that way.

That means that I am still owing my broker 90,000 USD. Given the exchange rate of 10 EUR = 1 USD, I have to use 900,000 EUR from my trading account for doing so.

Thus, I have lost 900,000 EUR during that trade which has been worth 100,000 EUR. Please note that this loss does not have anything to do with leverage! Of course, I know that it is a fundamental principle of FX trading that you could lose more money than you have available due to the leverage, but once again, we have assumed a leverage of 1:1 for that example!

Short EUR position ("sell")

Mentally going back to the initial situation, I now open a short position of 100,000 EUR. Technically, as far as I have understood, that means that I am taking a credit of 100,000 EUR from my broker and immediately am exchanging that money to 100,000 USD (exchange rate when opening is 1:1 as defined above). Thus, I now have 100,000 USD available at some virtual place, but I am owing my broker 100,000 EUR.

Now, let's assume that the exchange rate becomes 1 EUR = 10 USD (i.e. 0.1 EUR = 1 USD), i.e. the market changes in the wrong direction (from my point of view) by a factor of 10.

Then, when closing the position, I have to give my broker his credit back (100,000 EUR). When doing so, I am first taking the 100,000 USD from their virtual place, exchange them into EUR and give them back to my broker. Since the exchange rate is now 1 USD = 0.1 EUR, I give my broker only 10,000 EUR back that way.

That means that I am still owing my broker 90,000 EUR. This is bad, but I knew that I could lose 100,000 EUR if I would use 100,000 EUR for trading, and it is by far less surprising than the situation after the long trade.

Final question

Did I correctly understand what opening a trade technically is?

If yes, then we have seen that long EUR/USD trades are by far more dangerous than short ones, provided that your trading account currency is EUR (it would be the other way around if the trading account currency would be USD).

We have seen that (assuming the unrealistic preconditions of our examples) your loss with a long trade is 900% of the money you have used if the exchange rate goes into wrong direction by a factor of 10, but your loss with a short trade is only 90% of the money you have used if the exchange rate goes into wrong direction by a factor of 10 (or vice versa, depending on your trading account currency).

Thus, there is a leverage effect even when the leverage is 1:1 as assumed in our examples.

Did I get this right?

(Please note that I have consequently used stop loss in the past, so I never have suffered from drastic and fast market changes, but nevertheless, I am highly interested in completely understanding that issue).

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  • $\begingroup$ Sorry, I did not quite understand what is you Home Currency in this example. Is it EUR? $\endgroup$ – Alex C Feb 25 '17 at 12:42
  • $\begingroup$ Yes, my trading account currency is EUR (second item in my precondition list). Not being a native English speaker, I didn't know that this is called Home Currency. Sorry about that. $\endgroup$ – Binarus Feb 25 '17 at 12:50
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    $\begingroup$ The analysis is correct. The long trade is worth 100 - 100/FX, and the short trade is worth 100/FX -100, where FX=ending EURUSD exchange rate. The first expression has unlimited downside as FX->0, and the second expression is always > -100. $\endgroup$ – dm63 Feb 25 '17 at 12:52
  • $\begingroup$ Thanks and WOW. Now that is crazy. I already had come to the same conclusion, but hoped that I had made an error. $\endgroup$ – Binarus Feb 25 '17 at 12:57
  • $\begingroup$ Good question and good answer. Probably deserves to be made a formal answer instead of just a comment. $\endgroup$ – Alex C Feb 25 '17 at 13:34
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[Your] analysis is correct. The long trade is worth 100 - 100/FX, and the short trade is worth 100/FX -100, where FX=ending EURUSD exchange rate. The first expression has unlimited downside as FX -> 0, and the second expression is always > -100. ––– dm63 Feb 25, 2017 at 12:52

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  • $\begingroup$ Accepting your answer for the formulae (which are the same as I had elaborated myself), and upvoted (hoping that you formerly have been "dm63" and have not just copied his comment :-)). $\endgroup$ – Binarus Mar 31 '17 at 16:48
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I you take a long position in a stock the worst that can happen is the stock goes to zero, and you lose your investment.

If you take a short position in a stock, you have the potential for unlimited loss (since there is no limit to how high the stock can go).

Exactly the same principle pertains in FX. If your quote currency (or home currency) is EUR and you are buying USD, then long positions in USD (short positions in EUR/USD) can only lose your investment, but short positions in USD (long positions in EUR/USD) can lose multiples of your investment

It may help to think of a position in a stock, e.g. MSFT, as a MSFT/USD trade, since you are buying Microsoft stock for USD. Or to think of a position in a European stock (e.g. VOD) as a VOD/EUR position, to make the analogy clear.

Of course, thinking about the maximum amount of money you can lose on an investment is only one dimension of risk. I'd argue that it's not a particularly useful dimension, because the chances of a currency going to zero, or doubling, over any reasonable-length period (say a month) are close to zero. Instead, I would want to know what the typical size of movements in a currency are (its volatility), how does it co-move with other currencies I am holding (its correlation) and what is the relative size of up moves versus down moves (its skewness). I'd also look at macro risks (e.g. correlation with the stock market, likelihood of central bank interventions) before I started worrying about the risk asymmetry of long vs short positions in a currency.

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  • $\begingroup$ Thanks for the analogies, and upvoted, but giving the answer to Alex C since he has mentioned the formulae (which are the same as I had elaborated myself). $\endgroup$ – Binarus Mar 31 '17 at 16:45
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No you've not got your funding for a long or short position correct. An FX position is already fully funded from the start. Then at the end you simply own the PnL. Whereas what you're doing is adding in a kind of money market deposit or loan from the broker to fund your FX position.

What happens in FX:

Long: If you buy 100,000 EUR (go long) then you pay for that now (at the spot rate) using 100,000 USD (or simply 100,000 EUR). It doesn't really matter the funding currency but you have pay your broker now otherwise you don't get the EUR. From then on if the value of EUR goes up or down that's simply the value of the EUR that you already own. There's nothing more to pay.

Short: If you sell 100,000 EUR (go short) then you pay for that position now by giving the EUR to your broker, for which you take 100,000 USD (at the spot rate) in return. Then whether USD (or some other currency) goes up or down is just the inverse of long EUR. You can say you're actually long USDEUR. You're short EURUSD. When you want to "close" that position then your 100,000 USD (that you've also got on deposit somewhere at 1%) only gets you back 10,000 EUR so in your scenario you've lost the 90,000 but no more.

In your scenario you're imagining that to fund your FX position you've borrowed from the broker (via the money markets) as if you have no money in your trading account to fund a position yourself. So yes, if your broker lent you 1,100,000 EUR that you had to pay back and EURUSD lost 90% of it's value then you'd still have at least 1,000,000 EUR (which you would pay back) but that loan would only be worth 10% as many USD as before so actually your broker would have "lost" 900,000 from the EUR that they lent you. When you borrow a currency you repay it in the same currency you borrowed it, not in some other currency.

In your "short" scenario your broker lent you 1,100,000 EUR and then you used 100,000 EUR to buy 100,000 USD. Then the rate went to 1 EUR = 10 USD so yes EUR loses 90% of it's value. Your bet went wrong and you lost 90,000 USD but the thing is that you pay back your broker 1,010,000 EUR.

So you're getting confused about funding currencies, and loans, and PnL currencies for loans. Your broker lost big time on their EUR loan supposing their own PnL currency is USD. However, in reality they would have hedged that loan a long time before EURUSD lost 90% of its value.

Take a look at this explanation of the connection between FX and Money Markets

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  • $\begingroup$ Your analysis is correct when an EUR investor wants to lo long USD. They can fund it directly (no borrowing) like you suggest or they can fund it by borrowing through a broker. Your analysis is not correct when EUR based investor wants to go long EUR. In this case you have to borrow. You can borrow EUR from a domestic bank, which is OK, or you can borrow in a foreign currency (USD) and convert to EUR. The second case is dangerous if the domestic currency is sharply devalued. Every few years some Em Mkt companies go bankrupt when there is an FX crisis and they have borrowed in USD. $\endgroup$ – Alex C Mar 1 '17 at 4:58
  • $\begingroup$ How can a person who only owns EUR go long (additional) EUR? They have a printing press in the basement or something? They have to borrow it somehow. $\endgroup$ – Alex C Mar 1 '17 at 5:04
  • $\begingroup$ Well someone with EUR in their account is already long EUR. Still, this question isn't correct, there's no difference between long or short in FX. There is a difference between MM funding risks, yeah... but in this case the guy is already funded. He just does spot deals to change currency. $\endgroup$ – rupweb Mar 2 '17 at 9:56
  • $\begingroup$ @rupweb I do not think you are correct in my case. Before asking, I have consulted several serious sources which all state that if I am opening a long position in EUR, I am borrowing USD from by broker. This is at least true for all sort of account who came to my attention here in Germany. Please note that my example was extremely simplified. Consider that I usually can open a long position of 100K EUR even if I actually have only 1k EUR or 2K EUR at my account, so it should be clear that I am taking a credit $\endgroup$ – Binarus Mar 31 '17 at 16:40
  • $\begingroup$ Well then I think you ought to use another broker who doesn't confuse the financial instrument (long or short EURUSD) with the funding currency (EUR or USD or GBP or CHF or XXX) because provided you have funding currency (in any currency) then you don't need to borrow anything else to open a position. Then, the margin by which you trade 100K notional underlying for only 1K collateral is covered by your funding currency as well. The broker watches the PnL on your account and if at any time your position shows a loss > your funds, then he asks for variation margin..... does this help?!!! $\endgroup$ – rupweb Apr 5 '17 at 8:45

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