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 lose 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.
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).