Short selling is a common trading strategy used by investors and traders. It allows them to make profits from falling prices of assets, hedge existing holdings, and express a bearish outlook on the market. But it can be very high-risk, especially because of a phenomenon called ‘short squeeze’.
So, what is a short squeeze? It is a situation when there is a sudden increase in buying pressure due to a lot of short sellers being forced to close their positions. They buy to close their positions, leading to a dramatic spike in the price. The reason for this is that when the price goes up, these positions start to incur an unrealized loss. And traders close their positions to avoid even greater loss.
This type of situation can arise in any financial market where a short position can be taken. And the more liquidity there is to trap, the more the volatility due to a short squeeze. It’s the opposite of a long squeeze, which is a situation when long positions get trapped by cascading selling pressure, leading to a sharp downwards price spike.
So how does a short squeeze happen? It occurs when there is a sudden increase in buying pressure. This is what makes short squeeze very volatile, as there is a rush of buy orders. It can be triggered by stop-loss orders and liquidations or simply because traders manually close their positions. The amount of short interest present in a market matters as larger the short interest, easier is it to force the short sellers to close their positions.
Short squeezes are common in the stock market. This usually happens when there is low sentiment due to a perceived high stock price, along with a large number of short positions. Positive news can trigger the buying pressure and force the traders to close their positions. In cryptocurrency markets, it is also quite common. The derivative markets are highly levered, which makes it easy for traders to get trapped in sharp price moves. The best way to avoid getting trapped is to use proper risk management and limit the amount of leverage.
To sum up, a short squeeze can be an incredibly volatile event if you are not well-prepared. It happens when there is an increase in buying pressure due to a lot of short sellers being forced to close their positions. It is common in stock markets, as well as the cryptocurrency markets. The best way to limit the risk of a short squeeze is to use a good risk management strategy and keep an eye on the long/short ratio of the market.
