What is a Short Squeeze, and How It Works?

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Overview:

In this article, we will discuss the widely popular term Short Squeeze and how this condition affects traders in the crypto market. We will also talk about what causes short squeezes to occur, how traders can benefit from it and whether you can spot one in advance or not.

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What is a Short Squeeze?

To put it simply, a short squeeze is a condition that is triggered when a significant amount short sellers start turning into buyers due to a sudden rise in price. A short position is opened when a trader sells a stock/crypto first, intending to buy it back later at a lower price.

When there is a significant number of shorts position opened in the market and the price rises dramatically, it can create a panic buying situation. The sudden increase in the price will push the short sellers to cut their losses and buy the asset at the current market price.

Read: Why are cryptocurrencies dropping?

Every short seller that closes their position will automatically turn into a buyer, thus fueling the buying pressure even more. It starts a chain reaction that causes panic among short sellers, and most end up closing their positions. The reaction not only turns short sellers into buyers but also attracts other buyers who have been waiting on the sidelines for the price to go up.

Why do Short Sellers Close Their Position?

A short position allows a trader to sell an asset that they don’t own with the intention of buying it back at lower prices. Generally, a short trader enters into a position when they think the price will keep dropping in the near future. The lower the price drops, the more profit a short seller makes because they sold the asset already at a higher price.

However, when the speculation of short traders turns out to be wrong, they are forced to buy the asset at a higher price. When the price shoots up, the sellers will start getting margin calls, and they will either have to put more money at risk or cut their losses by closing their position. Naturally, the short sellers start buying the asset to minimize losses, and it starts a chain reaction where every seller wants to close their position.

The market turns bullish, and selling pressure decreases dramatically. Where short traders lose money in the event of a short squeeze, long traders benefit plenty from it.

Why do Short Squeezes Happen?

Short squeezes do not occur with a dramatic or rapid increase in price only. They happen when that spike comes during a time when there are plenty of short positions opened against that particular asset.

Whether it’s a stock or a cryptocurrency, short traders bet against their price when they believe it will decline soon. Their speculation is mostly based on technical analysis or fundamentals of that project.

When a sudden positive development comes to the surface related to the asset, it could really shift the momentum. For example, if it is a crypto project, some news about a partnership or a new update could shift the trend dramatically.

Read: Five Tips for Getting Started in Cryptocurrency

It causes the short sellers to reconsider their position and start buying the asset even if they have to take some losses. Remember, every short seller that closes their position automatically turns into a buyer, thus increasing the buying pressure even more. This starts a chain reaction, and the price keeps going up until all or most of the short positions are squeezed.

The Tesla Short Squeeze

An example of a short squeeze can be taken from the stock market when Tesla jumped 4x in price in 2020.

When Tesla announced that it would start producing and marketing electric vehicles, it turned around many heads. There was a lot of interest in Tesla during that time, and the stock was consistently going up. However, there were also traders who thought the stock was getting overpriced and would eventually plunge.

The short sellers bet so heavily on its failure that by the end of 2019, it was the most shorted stock in the stock market. The company kept flourishing, and eventually, at the beginning of 2020, the pressure got to the traders. A short squeeze was triggered, and the price started rocketing upwards. Tesla stock went up over 400% in that time period (early 2020).

How to Benefit from a Short Squeeze? Can It be Predicted?

A short squeeze can benefit traders who still believe in the asset and are betting in its favor. Short squeezes happen when there is a lot of doubt about the asset, and a good number of short positions are opened against it. For a long trader to bet in favor of the price at the time is always risky. If a trader can see a short squeeze coming, they can benefit heavily from it.

Predicting a short squeeze is quite challenging, but it is not impossible. Traders use many technical indicators that can tell them the likelihood of a short squeeze. These indicators include short interest, days to cover, and the Relative Strength Index (RSI).

Keep in mind that if a large number of shorts are opened against a certain stock or cryptocurrency, it doesn’t necessarily mean it is on the brink of a short squeeze. The risk is quite high here when you are betting in favor of the price when the market sentiment is against it. An asset on which the majority of the traders are bearish is likely to move in a downtrend in most cases.

Bottom Line:

A short squeeze can be quite exciting, especially if you are a long trader or like to HODL your crypto during rough patches. Short squeezes are quite rare and do not happen to every asset that is heavily shorted. They are more prevalent in the crypto space compared to the stock market due to high volatility. It is also advised that novice traders should not go out looking for short squeezes as they are extremely risky.

No one can really predict when they will happen and how far they will go. So it is better to tread carefully when you are dealing with a short squeeze.

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