Introduction
A short squeeze is a market phenomenon that occurs when a stock’s price rapidly increases due to a large number of short sellers being forced to cover their positions. This increase in price is often unexpected and can result in losses for those with short positions. Fortunately, there are a few strategies investors can use to protect their portfolio from these losses. In this article, we will explore the concept of short squeezes and how to avoid losses due to them.
08/05/2022
AdvancedTrading and investment
AdvancedTrading and investment
Main
- A short squeeze is a situation where an increase in the price of an asset is caused by an excessive accumulation of short positions, the closure of which creates additional demand for the purchase of an asset and leads to a further increase in the price.
- A short squeeze is characterized by a rapid increase in the price of an asset, increased trading volume and high volatility – this can lead to significant losses for traders trading short.
- To reduce the risk of getting into a short squeeze, you should use stop orders and hedging instruments, as well as use low leverage.
What is a short position (short)
Before talking about a short squeeze, you need to define a short position in trading, which is also called a “short” (from the English short – “short”). When opening a short, a trader borrows an asset from a broker or exchange, using their funds as collateral. You can close such a position by repurchasing a similar amount of the asset at the current price. Profit is generated when the price of an asset decreases.
For example, a market participant opened a short on the exchange for 1 BTC at a price of $30,000 per coin. After some time, the price of bitcoin fell to $25,000, and the trader decided to buy back the borrowed asset. The difference between the sale and purchase price, that is, $5,000, is profit.
An increase in the price of an asset after opening a short leads to losses. If the trader’s balance does not have enough own funds to cover them, a margin call occurs, which can lead to the forced closing of the position (liquidation).
How is a short squeeze formed?
One of the main reasons for the appearance of a short squeeze is a dense accumulation of open short positions at a certain price level. When quotes move up, market participants are forced to limit risks and close unprofitable shorts.
Since you need to buy an asset to close a short position, when its price rises, this only increases demand. This, in turn, pushes the price further higher, increasing losses for short position holders, and leading to mass liquidations.
The automated nature of modern trading on the stock exchange, possible panic and increased volumes can create huge price spikes of several tens of percent. Moreover, in some cases, a short squeeze can lead to a halt in asset trading.
A similar situation happened on the Nasdaq exchange with shares of Robinhood Market – due to volatility, trading in securities had to be stopped three times.
Short Squeeze Examples
Short squeeze is a fairly common occurrence in any markets, including cryptocurrency, below are two examples.
game stop
In November 2020, members of the WallStreetBets subreddit discovered hedge fund Melvin Capital’s open short positions in the shares of the GameStop (GME) chain of stores, which were in a near-bankrupt state.
Network “activists” decided to use this information and began buying GME shares on the stock exchange in order to keep the company from collapse. The movement took on a massive character, and in less than a month, GameStop quotes increased by more than 20 times.
The short squeeze resulted in a loss of 30% of Melvin Capital’s total capital, according to the Wall Street Journal, for a combined loss of $19.75 billion to GME shorts.
Celsius Network
In June 2022, crypto lending platform Celsius suspended withdrawals, exchanges and transfers between accounts due to extreme market conditions. All this led to a strong drop in the value of the native token of the CEL platform.
A group of enthusiasts, using the social network Twitter, decided to repeat the operation, similar to the GameStop short squeeze. The movement was organized around the hashtag #CELShortSqueeze.
According to information Decrypt, the main argument for the short squeeze was the fact that the Celsius platform suspended withdrawals, including CEL tokens. In addition to this, the company’s financial problems should have generated interest in shorts from traders and large companies.
The essence of the “operation” was to buy CEL tokens on the exchange and withdraw them to cold wallets so that no one could use these tokens for sale. As a result, on June 19-21, 2022, the price of CEL almost tripled – from $0.55 to $1.5.
How to protect yourself from a short squeeze
Short squeeze is a frequent occurrence in the cryptocurrency market due to the low liquidity of many crypto assets, the lack of hedging tools and weak legal regulation. To reduce the risks of a short squeeze, you can use the following mechanisms:
- Stop order. The easiest and most efficient way. It will keep your open short position from being completely liquidated and will save you from emotional decisions.
- Hedging. When opening a short, traders hedge it with a reverse transaction: if a short is opened, then you can open a long position (long) on the same asset. If the quotes go against the trader’s expectations, then the hedge position will reduce the loss.
- Spot transactions. Trading in the spot market eliminates any debt relationship between the trader and the platform – this removes any risk of liquidations. Such transactions are not intended to earn money by falling asset prices, but they will protect against most risks, especially for novice traders.
- Low leverage. Very often, traders trade with high leverage, which multiplies the risk of financial losses. According to the Binance exchange, in 2019, on average, 60% of futures trades were opened with 20x leverage, which is a high ratio. As Morgan Creek founder Mark Yusko said, leverage “never makes a bad investment good, but it often makes a good investment become a bad one.”
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Conclusion
A short squeeze is a situation that can cause significant losses to a trader if they are not aware of it. To avoid losses due to a short squeeze, it is important to stay informed on market news and to monitor short positions closely. It is also important to use appropriate risk management strategies and to diversify portfolios to avoid overexposure to any one security. By being aware of the potential of a short squeeze and taking steps to minimize its impact, traders can reduce their risk of losses.
FAQ
Q: What is a short squeeze and how to avoid losses due to it?
A: A short squeeze is a rapid increase in the price of a stock that occurs when there is a lack of supply to meet the demand of short sellers who must buy the stock to cover their short positions. To avoid losses due to a short squeeze, investors should closely monitor their short positions, avoid selling short when the stock is volatile or the market is uncertain, and use stop-loss orders to limit downside risk.
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