What Is a Short Squeeze?
Introduction
Traders can profit from a decline in the price of an asset by short selling the asset. The strategy is widely used by investors to mitigate downside risks, hedge existing holdings, or simply express their bearish outlook on the market. The downside of shorting is that there can be instances when it becomes an extremely high-risk trading strategy.
There is no upper limit to the price of an asset, and short squeezes are also a factor. Short squeezes are defined as a sharp increase of the price caused by the sudden sale of the asset. Many short sellers get "trapped" when this happens and they run for the exits to try and cover their positions as soon as possible.
To understand a short squeeze, first you will have to understand what shorting is in order to recognize what a short squeeze is. Throughout this article, we will talk about what a short squeeze is, how you can prepare for it, and even how to profit from it if you are long position.
What is a short squeeze?
A short squeeze when a large number of short sellers are forced out of their positions, resulting in a sharp increase in the price of an asset. The short seller is betting that the asset's price will decline. Alternatively, if the price rises instead, short positions will start to accrue losses that have not yet been realized. If the price increases, short sellers may find themselves having to close their positions as the price rises.
Depending on the market, this can happen through stop-loss triggers, liquidations (for margins and futures contracts), etc. There is also a possibility that it may be due to traders manually closing their positions in order to avoid increasing losses.
What is the process by which short sellers close their positions? Typically, they buy. In this manner, a short squeeze leads to the price spike that we see in the market. The cascading effect of buy orders that occur as short sellers close their positions fuels the fire further. In addition, a short squeeze is typically accompanied by a similar surge in trading volume.
Here's another factor to consider. Consequently, if there is a large short interest, then it is easier for short sellers to be trapped, forcing them to close their positions. Hence, if there is more liquidity to trap, then the increase in volatility may be greater due to a short squeeze as a result of more liquidity getting trapped. The term short squeeze is used in this sense when there is a temporary rise in demand together with a temporary fall in supply.
A long squeeze is the opposite of a short squeeze, although it is less common. There is also an effect known as a long squeeze that occurs when long positions are trapped under cascading selling pressure, which results in a sharp decline in price.
How does a short squeeze happen?
When the buying pressure is increased suddenly, there is a short squeeze that occurs. A short squeeze is likely to cause a rapid rush to cover short positions (through buy orders), which is what makes a squeeze a particularly volatile event. There were many stop-loss orders that were triggered at a significant price and there were many short sellers that had closed their positions manually at the same time at a significant price level.
It is possible for short squeezes to occur on virtually any financial market in which it is possible to take a short position. As well as this, the inability to short a market can also cause large price bubbles if there are no options for doing so. The truth is that if we do not know how to bet against an asset, it will likely continue to rise for an extended period of time.
In order for a short squeeze to take place, it can be necessary to have a majority of short positions over long positions. There is no question that if there are significantly more short positions than there are long positions, the fire is going to have a lot more fuel when there is more liquidity available. Traders who are interested in keeping an eye on market sentiment can make good use of the long/short ratio to keep track of the market's sentiment at any time.
Advanced traders might be looking for potential opportunities to capitalize on short squeezes and profit from the price spike resulting from a short squeeze. Using this strategy, one will accumulate positions before the squeeze occurs and then use the quick spike to take advantage of a higher price.
Short squeeze examples
It is very common in the stock market for short squeezes to occur. There usually are three factors involved in equity short-selling: a low perception of a company's stock price, a high stock price, and a large number of short positions. For example, if some unexpectedly positive news is announced, all these short positions are forced to buy the stock, which leads to the increase in its price. In spite of this, a short squeeze is most often considered to be a technical pattern, rather than a fundamental occurrence.
There are some reports that Tesla (TSLA) stock was the most shorted stock in history. In spite of this, the price of the stock has experienced a number of price increases, likely trapping a large number of short sellers.
Cryptocurrency markets are also quite prone to short squeezes. Most notably, one can see this on the Bitcoin market. The Bitcoin derivatives market utilizes high-leverage positions, which are susceptible to being liquidated or trapped with relatively small price changes. This is one of the reasons why short and long squeezes occur quite frequently in the Bitcoin market. Consider carefully how much leverage you're using before you execute such a move if you'd like to avoid becoming liquidated or trapped by such actions. Furthermore, you need to ensure that you have a proper risk management system in place.