Traders find themselves in either a long or short position depending on their interpretation of upcoming market conditions. From time to time, traders’ predictions of the market will be wrong, resulting in their funds being liquidated, taking significant losses. One of the most common causes of liquidation in trading is when a trader is being short-squeezed, in other words, being forced to close their short-sell positions due to losses.
Definition
A short squeeze is a phenomenon where a trader is in a short position expecting general prices to decrease. However, in reality, there is a sudden and rapid increase in price.
Why does a short squeeze happen?
A short squeeze happens when a large portion of traders or a group of ‘whales’ share a bullish sentiment. They attempt to drive out the ‘bears’ in the market by either liquidating them or forcing their hand into making substantial losses.
Sometimes, a short squeeze is not directed by groups of investors. A company could have a big announcement that brings positive press to its brand. This will cause a sudden and steep increase in the prices of their stocks. Likewise, if a country has a change in policy to appreciate their currency, short-investors might be squeezed out. However, realistically, this would not happen with currencies as it takes a long time to pass a law. Therefore all changes will have been preempted.
How to benefit from a short squeeze?
The simple answer is: do not be in a short position when there are changes in market sentiment.
To successfully trade, you will need to keep up with current global events as well as the psychology of other traders. When there is a heavy-shorting period, you will need to identify whether this is due to an external factor that causes a bearish sentiment, or it could be a trap for a short squeeze. If you identify it as a trap, go against the current sentiment to maximise returns on your long position.
The famous example of a short squeeze
In January 2021, major hedge funds had a short position on a diminishing distributor of video games, Gamestop. As an act of rebellion, the Reddit community came together to short squeeze these major hedge funds. They began buying to drive up the stock and force these funds to take massive losses as institutions were buying back shares to cover their positions.
Final words
There will always be inherent risk in trading shortable assets. If you are an active trader, there is a high chance you will be short squeezed out of your position. However, to avoid falling into this trap or even benefit from it when the stars align, you will need to do careful analysis on trends of price and market sentiments.
