A short squeeze also called a bear squeeze, is when, in financial markets, the price of an asset goes up quickly, pressuring short sellers to close their positions by buying back their tokens at a higher price. In the cryptocurrency market, a short squeeze is often seen as a market manipulation incident because the price action usually goes against what would be expected for the asset and is often caused by a range of participants acting semi-coordinately.
Short squeezes can be great ways for some people to make a lot of money. They can be financially devastating for others because they can mess up even the most well-thought-out short-term plans. Here’s everything you need to learn about this relatively common thing that happens in the financial world.
What is a short squeeze?
If you’re a crypto trader, a short squeeze is basically one method to extract maximum value in minimum time. When a cryptocurrency’s price has been falling for extended periods, there comes a time when the traders “shorting” the asset (selling first to buy lower later), voluntarily or involuntarily close their positions (due to need for profit taking, or late shorters getting caught if the price goes up). This is known as a “short squeeze.” As the stock price increases in response to these short sellers’ purchases, the late shorters may be forced to “cover” or buy back their positions to prevent a loss. All this buying activity causes prices to go further up — thus it’s called a squeeze.
In short (pun unintended!), short sellers are squeezed when any asset’s price drops for extended periods and then sharply rises, causing many short sellers to cover their positions and take a loss.
How does a short squeeze work?
Let’s break down how a brief squeeze works into two steps. Short selling entails two stages: (1) selling the crypto asset and then (2) (obligatorily) repurchasing the crypto to close your position and take profits.
Let’s say XYZ crypto has been generating excitement in the crypto market, enticing purchasers to invest in it because of its strong performance and its forecast to continue to rise. Short sellers think XYZ’s crypto value will drop, and it’s on a transitory uptrend. Short sellers will borrow shares of XYZ crypto from their exchange to sell, expecting the crypto price to fall, allowing them to repurchase the crypto at a lower price and earn a profit.
When short sellers acquire XYZ crypto to close their positions later, they become purchasers. Since there are both new buyers and short sellers (who become purchasers in the second phase), the price of XYZ crypto should continue to rise. This will enhance XYZ’s price and make short sellers worried that the crypto is growing instead of falling. This will cause more short sellers to purchase back XYZ crypto to limit their loss. Because of XYZ’s rising value, regular purchasers will continue buying crypto. When this happens, long-term investors looking to benefit from XYZ’s performance and short-term investors looking to limit their losses buy the crypto. A quick rise in XYZ crypto squeezes out short sellers in this case.
What Happens in a Short Squeeze?
Most of the time, a short squeeze happens after a crypto’s price has been going down for a while. The price drop brings in an increasing number of short sellers who want to make money from the price drop. A squeeze that follows is caused by one of two things.
It could be unexpectedly good news about the crypto, like unexpected adoption news. Technical traders may also start buying the asset if they see signs that it has been sold off too much and could be ready to move back up. Short sellers watch their earnings diminish or turn into losses as the newly introduced buying pressure drives the crypto price substantially upward.
They place a purchase order to cover their short positions in the crypto out of fear that the price will continue to rise. Putting up buy orders to cover their short parts encourages more investors to purchase the crypto, increasing the price.
Increases in the crypto price eventually force away short sellers.
Risks of short squeeze trading
Your portfolio might suffer significantly if you choose to go long or short during a short squeeze due to the following risks:
1. Short squeeze may continue (or not): You won’t know how long a brief squeeze will last once it’s over. Some companies might linger above their fair market value for years after spiking during the squeeze.
2. Short interest is vital for good reason: Short sellers are well-informed investors. Thus their shorting a company should alert long-term investors. There’s usually a rationale for a crypto’s strong short interest.
3. Too much potential: If you purchase after a short squeeze has skyrocketed, you may buy around the top or a local maximum. If you short-sell crypto after it’s risen, you risk the crypto rising more and the squeeze not ending. If you need to correct it, you might rapidly lose money.
4. Market timing: You’re attempting to time the market or outguess other traders if you trade a short squeeze. The crypto market may gain or lose money swiftly in the short term.
Short squeezes are generally driven by technical considerations (short sellers closing their positions) instead of fundamental ones (business performance), so long investors must comprehend the company’s long-term prospects. Longing might be advantageous if short sellers are wrong and the company isn’t overpriced or harmed.
Conclusion
Short squeezes may benefit purchasers. Sellers face huge losses if their crypto projections come out differently than they want to. They must return borrowed shares to their broker regardless of performance. They may benefit from this approach, but losses may exceed profits. Understanding how short and long crypto holdings may help or risk your portfolio at risk.
Disclaimer: Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions.
