Introduction

Short selling allows traders to profit from falling asset prices. This is a common way to manage downside risk, hedge existing positions, or bearish market prospects.  

However, short selling strategies sometimes involve extremely high risks. Because it has no upper limit on asset prices and is closely related to short squeezes. A short squeeze can be thought of as a sudden surge in prices. When this happens, many short sellers are "trapped" and will try to sell out quickly to cover their positions.

If you want to understand what a short squeeze is, you first need to understand what short selling is. If you are not familiar with short selling and how it works, please read "What does short selling mean in financial markets?" 》.

In this article, we will discuss what a short squeeze is, how to respond to a short squeeze, and how to profit from a long position.

What is a short squeeze?

A large number of short sellers are forced to liquidate their positions, causing asset prices to rise sharply, which will trigger a short squeeze.

Short sellers predict a fall in asset prices. If the price rises instead, the short position's unrealized losses will grow larger. As prices rise, short sellers will face forced liquidation. This is triggered via a stop loss order, while margin and futures contracts force liquidation directly. There may also be traders closing positions manually to avoid greater losses.

So, how do short sellers close their positions? They will buy. This is why a short squeeze can cause prices to rise sharply. As short sellers close their positions, the knock-on effect of buy orders will also add fuel to the fire. As a result, short squeezes are often accompanied by a corresponding surge in volume.

There are other considerations below. The greater the profit temptation of short selling, the easier it is for short sellers to get trapped and force themselves to close their positions. In other words, the more liquidity is locked up, the greater the volatility caused by the short squeeze. In this sense, a short squeeze creates a temporary increase in demand and a decrease in supply.

The opposite of a short squeeze is a long squeeze, which is uncommon. A similar bull squeeze occurs when longs are besieged by a cascade of selling pressure, causing prices to fall sharply.

How does the short squeeze happen?

A short squeeze occurs when buying pressure suddenly increases. If you've read about shorting, you know that shorting is a high-risk strategy. However, the sudden and rapid covering of short positions via buy orders is what triggers this particular volatile event called a short squeeze. These include many stop-loss orders being triggered at high price levels, as well as numerous short sellers manually closing their positions at the same time.

As long as short positions can be established in financial markets, a short squeeze is likely to occur. At the same time, if there are fewer options for shorting the market, a huge price bubble will also occur. After all, without a suitable way to short an asset, the asset may continue to rise over a long period of time.

The premise for a short squeeze to occur is that short positions overwhelmingly outnumber long positions. Naturally, if there are significantly more short positions than long positions, there will be stronger liquidity adding fuel to the fire. Therefore, traders who want to keep a close eye on market sentiment look to the long/short ratio as a useful evaluation tool. To view live long/short ratios for Binance futures, click this page.

Some advanced traders will wait and see for potential short squeeze opportunities and go long to profit from rapid price increases. The strategy involves accumulating positions before a short squeeze occurs and taking advantage of a rapid surge to sell high.

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Short squeeze example

Short squeezes are very common in the stock market. The aftermath is often accompanied by low sentiment about the company, predictions of rising stock prices, and large short positions. For example, suppose there is unexpected good news and all short positions are forced to buy, causing the stock price to rise. Even so, the short squeeze bias is a technical pattern, not a fundamental event.

Tesla (TSLA) stock is estimated to be one of the most shorted stocks in history. Even so, the price has experienced many large price increases, leaving many short sellers trapped.

Short squeezes are also very common in the cryptocurrency market, especially the Bitcoin market. The Bitcoin derivatives market uses highly leveraged positions, and even relatively small price changes can lead to lock-ups or forced liquidations. Therefore, both short squeezes and long squeezes occur frequently in the Bitcoin market. Carefully consider the amount of leverage you use if you want to avoid being stuck or liquidated. At the same time, appropriate risk management strategies should also be adopted.

Let’s look at the following Bitcoin price range in early 2019. After a sharp decline, the price remains within a certain range. Sentiment is likely to be very subdued as many investors wait and see short positions in hopes of a continuation of the downtrend.

Potential short squeeze in BTC/USD market.

However, as prices quickly broke out of this range, this price area was not tested again for a long time. It was not until the later COVID-19 epidemic that it was tested again, known as "Black Thursday". Prices moved rapidly due to heavy short covering.

Summary

In short, when short sellers are forced to close their positions and the price rises sharply, it will A short squeeze occurs.  

In highly leveraged markets, short squeezes are volatile. When many traders and investors use high leverage, price changes are more dramatic due to the waterfall effect caused by continuous liquidation.

Before you decide to enter a short position, be sure to understand the consequences of a short squeeze. Otherwise, you may suffer heavy losses. To learn more about short selling and other trading techniques, read The Complete Guide to Cryptocurrency Trading for Beginners.