Understanding short squeezes in financial market trading

TL;DR

🔹 A short squeeze occurs when many investors bet against a stock, but its price rises instead.
🔹 A short squeeze causes a stock's or asset’s price to rise faster as short sellers exit to cut their losses.
🔹 One of the ways to foresee a short squeeze is to look at an asset's short interest percentage, as a sharp increase or decrease in short-term interest can be highly revealing.
🔹 You can avoid being caught up in a short squeeze by using highly liquid exchanges, avoiding high leverages, and being wary of manipulation attempts.




Introduction
Short selling is a common practice that keeps investors and businesses on their toes. Holding an investment is only worthwhile if you know it can be sold. Traders will also short an asset if it appears to be overvalued.

With regulators tightening KYC requirements and banning anonymous transactions, the sentiment toward privacy tokens in cryptocurrencies is rather gloomy. Since mid-2020, the number of shorts on Monero, arguably the most prominent privacy coin in the blockchain space, has been increasing. According to Datamish, it currently has more shorts than longs. Shorting an asset entails borrowing, selling, and then buying it at a lower price to return it. Shorting an asset is a bet on the asset's depreciation, while profit is the amount left over after deducting interest. However, if the market does not follow the trader's prediction and the asset rises, traders will repurchase in a frenzy to minimize losses.

On this premise, we shall look at short squeezes in financial market trading.

What is a Short squeeze?

During a sudden market movement, short-sellers will repurchase an asset in large numbers, creating momentum that pushes the asset and its price ever higher. This action drives short sellers out of the market, usually at a loss. In 2008, a short squeeze increased Volkswagen shares by 5x in just two days, briefly making it the world's most valuable company. With an 18% short interest, Tesla's 400% rise from late 2019 to early 2020 cost short-sellers more than $8 billion. However, its decline in March returned $50 billion to their pockets in just a few days.

An unusual circumstance called a "short squeeze" causes stock prices or other tradable securities to rise quickly. It happens when a security has a large number of short sellers, which means that many investors are betting on its price falling. The short squeeze starts when the price unexpectedly jumps and gains momentum as a significant portion of the short sellers chooses to cut losses and exit their positions.

Short-squeezes in Crypto Market
A short squeeze is frequently described as a market manipulation event in cryptocurrency markets because the price action usually defies the expected path of the asset and frequently involves the semi-coordinated actions of many participants.

In just one day, Bitcoin jumped from under $9,500 to a 4-month high of nearly $10,400 in June 2020. Over $430 million in Bitcoin shorts were liquidated across all platforms in less than 24 hours, with the majority occurring within an hour of Bitcoin reaching $10,000. Short squeezes frequently occur in cryptocurrency markets, most notably in Bitcoin markets. Some Bitcoin derivatives markets employ high-leverage positions that can be liquidated despite relatively minor price movements. In volatile markets like cryptocurrencies, limiting your leverage and implementing better risk management strategies is the best way to avoid being liquidated.

How does a short squeeze work?

When a short seller opens a position, they typically borrow and sell the number of tokens they want to short.

When they decide to exit their position, they buy back the same number of borrowed tokens, returning them to the lender to complete the loan. The difference between the price at which they sold their borrowed tokens and the price at which they repurchased them is held as profit (minus trading and funding fees).

Such trading would be considered a profitable transaction.

On the other hand, should the price move against their trades, they are forced to repurchase the tokens at a higher price than they originally sold. As a result, there is a loss. Shorts are frequently forced out of their positions when their stop-loss triggers or they are liquidated (if shorting derivatives).

A short squeeze occurs when the market flicks in the bullish direction, forcing many short sellers to close their positions (often at a loss) while increasing buying pressure. This pressure may trigger a runaway incident that further drives up the price from short sellers buying back their tokens to pay off their loans. This event forces additional short sellers out of their positions, and so on.

Is short-squeeze profitable?

Investors who go against the grain regularly purchase assets with high short interest to profit from potential short squeezes. Profiting during a squeeze is highly appealing, but it involves some risks. Perhaps the shorts were reasonable in assessing the asset's value, and the sudden rise is only temporary.

Active traders regularly observe highly shorted assets entering just as the squeeze begins. Nonetheless, while numerous examples of stocks have been short-squeezed due to high short interest, there are also assets with high short interest that have continued to fall in value.

High short interest does not always indicate a short squeeze but rather that a large chunk of the market believes the asset is overvalued. Investing in such assets solely based on short interest is a bad idea, especially since a large portion of the market believes it will fall in value. When combined with signals from other indicators, trading high short-interest assets can be highly profitable.

How to predict a short squeeze

It is nearly impossible to predict a short squeeze every time accurately, but by tracking heavily shorted assets, traders can quickly respond when one occurs.

The first metric to look for is an asset's short interest percentage, calculated by dividing the number of shorts by the number of outstanding shares. It is expressed as a percentage, and the higher its value, the more short-sellers there will be during a squeeze. A sharp increase or decrease in short-term interest can be highly revealing. Even a 10% increase in short interest indicates that one-tenth of the market has gone short on the asset, which is a reasonable signal to investigate further.

Bullish investors see high short interest as a chance to profit from the abrupt momentum shift. Short-sellers reduce supply during a squeeze by scrambling to replace borrowed assets. Because short squeezes occur more frequently with smaller market cap assets, a supply bottleneck can quickly emerge.

How to Avoid Being Caught in a Short Squeeze

There are several proactive ways to defend yourself against short squeezes.
These are some examples:

• Avoid using high leverages:
Most short squeezes are transient events that last only a few hours or days. By avoiding high leverage, you can reduce the likelihood of your position being pushed past its liquidation threshold, ensuring your solvency until the squeeze eventually fails.

• Avoid the use of exchanges with short liquidity:
Short squeezes are far easier to execute on highly liquid exchanges. By avoiding these platforms, you can reduce your chances of being caught in the initial volume attack that sets off a chain reaction of liquidations.

• Avoid using high leverages:
Most short squeezes are transient events that last only a few hours or days. By avoiding high leverage, you can reduce the likelihood of your position being pushed past its liquidation threshold, ensuring your solvency until the squeeze eventually fails.

• Monitor brief activity:
Markets with a high short-to-long trader ratio are prime targets for short squeezes. You can monitor the short interest ratio (short interest / daily trading volume). The greater this number, the greater the possibility of a short squeeze.

• Refrain from chasing losses:
Chasing losses may not be a good idea if you've been stopped out or liquidated by a short squeeze. While most short squeezes are fleeting, some are remarkably persistent and can propel assets to extraordinary heights. Predicting the top can be rugged, and wrong predictions can result in significant losses.

Conclusion

Short squeezes are not something to be afraid of unless you're short-selling for speculative purposes. A short squeeze is nothing more than an opportunity to profit if you have the right signals from different indicators combined with insight into the state of the asset in question.



Author - M. Olatunji, Gate.io Researcher
* This article represents only the views of the observers and does not constitute any investment suggestions.
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