A short happens when a heavily shorted asset suddenly surges and pushing short traders to close their position to avoid a loss. We seen it happen with AMC and GME but how it really work?
TL;DR
- A short squeeze happens when a shorted crypto suddenly surges and short traders close their position to avoid a loss.
- A short squeeze usually happens due to unprecedented fundamental factors that cause a sudden change in market sentiment.
- There are three ways to avoid a short squeeze: set a buy order limit (stop-loss); bet against your guts and look for early tell-tale signs.
- If you’re not interested in crypto trading, you can still earn a significant amount of income from crypto.
When a large number of short traders suddenly enter a buy order to cover their borrowed asset, will cause a short squeeze and this can happen with traditional assets like stocks or even alternative assets like cryptocurrencies. When this happens and retail investors like you and I see a buy signal and enter the purchasing frenzy, the market experiences a sudden price spike, which amplifies the loss for short traders.
What triggers a short squeeze?
When an asset that is experiencing a temporary correction gets shorted by too many short traders due to poor market sentiment and other fundamental factors, this sets up for a perfect short squeeze. If there is a sudden change in sentiment or an increase in buying pressure, this will trigger a short squeeze. With the sudden surge in price, short traders will need to make moves quickly to minimize their losses.
Shorting basically means borrowing an asset at a high price and then buying it at a discounted price when the asset is in decline. Therefore, shorting requires a decline in the price of an asset. If the market surges, short traders are forced to buy at a higher price. One way this might happen is through stop-loss triggers. This may also occur when traders sell their holdings voluntarily to prevent further losses. This leads to a surge of buying pressure that drives prices higher.
As prices continue to increase, the asset becomes more appealing to investors. Rising prices caused by new buys and losing short traders can be shocking and unprecedented. This phenomenon is called a “Short Squeeze."
How does a short squeeze happen?
In the market, there are short traders' who open positions when they believe a decline in price is about to happen, this strategy works really well in a bear market because as the price of the token falls, the profit of the trader increases. However, external factors can come into play that will shatter market expectations, such as new developments, inadvertent promotions from celebrities, announcements from the founders, or future adoptions of famous brands.
These factors can drive the prices of the said asset upwards. When this happens, the short sellers will start incurring paper losses, the upsurge in the price might just be temporary but if the prices continue to surge upwards, it will start the snowball of the short seller's losses.
Short Squeeze in Crypto
In the cryptocurrency markets, especially Bitcoin, short squeezes are fairly prevalent. High-leverage positions are used in the Bitcoin futures and options markets, where they get trapped even with slight price changes.
Though the Bitcoin markets commonly experience a short squeeze having good risk management strategies like utilizing the right amount of leverage can prevent you from getting stuck in a short squeeze situation.
In 2019, we can see that short traders are anticipating an imminent price decline in Bitcoin after a precipitous drop. The mood on the market was probably fairly pessimistic, with many traders seeking short positions in anticipation of the downtrend's continuance. However, the price found support in a narrow band, which triggered a sharp reversal.
The price quickly broke through the range, and the territory didn't even experience a retest for quite some time. It wasn't until the coronavirus pandemic (or "Black Thursday") that the price range was tested again. The massive number of buy orders from short traders is one of the reasons behind this sudden price surge.
Risk Management Tactics to Avoid a Short Squeeze Scenario
There are several ways to avoid being trapped in a short-squeeze situation – or at least lessen your losses when the house goes down.
By setting a strategic stop-loss level (in this case, a limit for buy orders) you can minimize your losses if/when a short squeeze happens. For instance, if you're looking to buy a cryptocurrency that’s about to experience a significant drop, you can set a limit to your buy orders of around a certain amount. Depending on your strategies, you have to set a strategic percentage that will allow you to buy the asset once the price hits that level, which prevents further losses.
Otherwise, you can consider hedging your shorts by owning the asset. This strategy can offset your losses in case a price spike happens. An alternative to this is purchasing derivatives to profit from the rising prices.
Signs that a short squeeze is about to happen
Day traders can spot early signs of a short squeeze by weighing in on the overall market pulse, fundamental indicators, and contrarian signals. Leveraging on such knowledge, traders can close a position earlier preventing any losses. In some cases, reading the signs can also help to further take advantage of a real shorting opportunity by re-entering the position once the price starts falling again.
Strong Buying Pressure
For no apparent reason, you may see that the asset has accumulated a massive number of buy orders. When this happens, you might be missing something or a short squeeze is about to happen.
Increased Short Interest
You can gauge the number of outstanding shorted assets by looking at the percentage of the crypto’s “short interest”. This is a useful insight to avoid a short squeeze because anything above 20 percent may signal an impending surge.
