Introduction
Short positions allow traders to profit from declining prices and are a very common way to manage risk, hedge assets, or simply express a bearish view of the market.
However, shorting can also be viewed from the point of view of a very risky trading strategy. In this case, the risk lies not only in the absence of an upper limit on the price of the asset, but also in the likelihood of a short squeeze, which can be described as a sharp increase in price. When this happens, many traders fall into the trap and rush to close positions.
But before we talk about short squeeze, we need to understand what shorting is. To learn more about shorting and its mechanisms, we recommend that you read the article What is shorting in financial markets?
In this article we will discuss what a short squeeze is, how to prepare for it and how to make money on it through long positions.
What is a short squeeze
A short squeeze occurs when the price of an asset rises sharply due to many traders being forced to close positions.
Traders open short positions, hoping that the price of an asset will decrease. If the price rises, short positions begin to generate unrealized losses. As prices rise, traders are forced to close positions, for example through stop loss and liquidation mechanisms (for margin and futures contracts). This can also happen simply because traders manually close positions to avoid even greater losses.
How do traders close positions? They buy. This is why a short squeeze causes prices to spike. When traders close positions, the cascading effect leads to massive buying of orders. Thus, a short squeeze is usually accompanied by an equivalent surge in trading volume.
However, it is worth considering some other factors. As prices rise, traders are forced to close positions. Moreover, the more money is at stake, the higher the probability of closure. In other words, in the case of a short squeeze, volatility will be directly proportional to liquidity. Thus, a short squeeze means a temporary increase in demand while supply decreases.
The opposite of a short squeeze is a long squeeze, although it is less common. A long squeeze triggers a similar effect when long positions become trapped in cascading pressure from traders, causing the price to spike lower.
How does a short squeeze happen?
A short squeeze occurs when buying pressure increases sharply. In the article on shorting, we already wrote that this can be a very risky trading strategy, since a short squeeze is extremely volatile and is accompanied by a sudden desire to cover short positions (through buy orders). This reaction is caused by multiple stop losses being triggered at a certain price level, causing a large number of traders to begin closing positions at the same time.
A short squeeze can occur in almost any financial market where a short position can be taken. At the same time, the lack of shorting opportunities can also lead to the formation of large price bubbles. For example, if traders do not bet against an asset for a long time, it may continue to rise.
A prerequisite for a short squeeze may be the predominance of short positions over long ones. Naturally, if there are significantly more short positions than long positions, more liquidity appears. This is why long-short ratio information can be a useful tool for traders who monitor market sentiment. To check the real-time long/short ratio for Binance Futures, please visit this page.
Some experienced traders wait for a short squeeze to occur so they can enter a long position and profit from a quick price move. This strategy involves accumulating a position before a short squeeze and using the spike to sell at a higher price.
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Examples of short squeezes
Short squeezes are very common in the stock market. They usually entail low sentiment towards a company with a high share price and a large number of short positions. At the same time, positive changes in the company lead to forced selling of short positions, as a result of which the stock price increases. And even in this case, the short squeeze is more of a technical pattern than a fundamental event.
By some estimates, Tesla (TSLA) stock was one of the most shorted shares in history. Their price has undergone a series of sharp spikes, likely trapping many traders.
Short squeezes are also quite common in the cryptocurrency markets, especially Bitcoin. The Bitcoin derivatives market uses highly leveraged positions that can be closed or liquidated in the event of even small price movements. Thus, both short squeezes and long squeezes occur frequently in Bitcoin markets. To avoid falling into this trap, carefully evaluate the amount of leverage you use and choose the right risk management strategy.
Take a look at the price movement of Bitcoin since the beginning of 2019. The price remained in the range after a sharp downward movement. Market sentiment was likely quite low as many investors took short positions expecting the downtrend to continue.
Potential short squeeze in the BTC/USD market.
However, the price went out of range, and the site was not even retested for a long time. The price only returned to its previous level years later during the coronavirus pandemic (known as Black Thursday). However, a spike was likely due to excessive short covering.
Summary
So, a short squeeze occurs when traders who are short become trapped. This leads to a sharp rise in prices due to the massive closure of positions.
Short squeeze can be especially volatile in high leverage markets. When many traders and investors use high leverage, price fluctuations become more extreme as cascading liquidations result in a waterfall effect.
Carefully review the implications of a short squeeze before entering a short position to avoid serious losses. To learn more about shorting and other trading techniques, check out The Complete Beginner's Guide to Cryptocurrency Trading.
