Short Squeeze Explained: How It Works and How to Trade It

Short Squeeze | Introduction

Shorting lets traders keep making profits on a declining asset or market. It’s a classic move in asset management during a bear market.

Shorting also lets you reduce your risk and hedge your portfolio of assets in a correcting market, as I’ve mentioned many times when it comes to hedging.

Either way, shorting is a particularly risky strategy!

The first reason is that there’s no defined price ceiling for an asset. And yet, when you trade crypto, you’re particularly well placed to know it at the time I’m writing these lines (10/02/2021).

The second phenomenon that would expose you to risk exponentially is the Short Squeeze!

A short squeeze is defined, among other things, by a sudden increase in price. When an asset spikes abruptly, the shorts find themselves trapped and scramble to exit their positions as fast as possible to cover themselves.

Naturally, if you want to understand the short squeeze, it’s first important to master the concept of the Short.

If you’re not yet familiar with it, I invite you to check out our article or our Video Tutorial on the subject first.

In this article, then, we’ll cover what a short squeeze represents and what it implies for you — traders or future traders. The goal is to prepare you for it so you can make the most of it on Long positions for example!

Short Squeeze | Definition

As mentioned earlier, you recognize a short squeeze when an asset rises suddenly and forcefully, because a large number of short positions are being closed out.

Short sellers bet that the price is going to fall… If the price reacts the other way, short positions start racking up losses with no limit. The kind of situation that reeks of liquidation!

This can happen because a large number of stop-losses get triggered, or because many liquidations kick in automatically for those who didn’t place their stop-loss properly. It can also happen when traders manually close their positions to avoid losses or too big a missed gain.

When a trader stops betting on the downside, they automatically do the opposite and buy!

That’s why a short squeeze necessarily implies a sudden rise, and that’s when the fire blazes up exponentially! On top of that, you’ll notice a volume spike that does the shorts no favors either!

What’s more, if a large majority of traders have bet on an imminent price drop, it becomes easier to trap them and force them to close their positions. In other words, the more liquidity is at stake, the greater the expansion and volatility of the short squeeze.

A short squeeze therefore amounts to a spike in demand, while the available supply drops just as suddenly.

The opposite of a short squeeze is the long squeeze, though this phenomenon is far rarer!

As you’ll have gathered, a long squeeze happens on an asset when a large number of long positions get trapped. In similar fashion, a long squeeze occurs when an asset drops too far for traders to lock in their trade. You’ll then see the reverse effect and a sudden decline, because traders start to sell and dump large amounts of unwanted liquidity onto the market. Conversely, it’s a snowball effect and the price falls flat on its face!

The Trigger Signals to Watch For

A Short Squeeze comes with a sudden surge in buying pressure. If you’ve studied our content on options, you already know that shorting is especially risky. It’s a point I stress a lot, because I rarely short myself — either because of this, or else my risk is perfectly measured.

What makes a short squeeze so interesting to understand comes precisely from the fact that it’s so risky! That doesn’t mean you should be afraid of it. It’s more a matter of:

1. first, warning you: only bet on the downside with CONSIDERABLE experience!
2. guiding you through understanding this concept
3. so as to prepare you — even condition you — to profit from it!

The short squeeze is a particularly volatile event, which means you can profit from a sudden rise if you saw it coming and built it into your plan. Large buy orders are generally lined up as well to cover the short positions in return, which is why this phenomenon is worth understanding. So rather than betting on the downside, whether by selling or shorting, I’d instead suggest getting ready to be among those hunting the stop-losses and the abrupt short exits at certain critical levels! Learn to take advantage of a short squeeze!

By the way, a short squeeze can happen on any market that offers the ability to short. You may even notice that a market with relatively few ways to short can easily lead to big bubbles! After all, if there’s no good reason to bet against a security, why would it fall?!

One of the prerequisites for a short squeeze to appear is that there are more shorts than longs. In short, the majority has to think it’s going to fall… The bigger the difference, the bigger the imbalance, the greater the liquidity there is to light the powder keg.

That’s why the long/short ratio can be useful to traders as a way to gauge the overall sentiment in the market. There’s no smoke without fire!

Plenty of data sites like Viewbase or Bybit let you track long/short ratios.

This is why the savviest traders watch short squeezes with appetite by placing long or buy orders to profit from the sudden spikes, just as I suggested you consider earlier.

This strategy involves accumulating ahead of the short squeeze so you can ride the sudden surge and sell into a price that will climb very high very fast, quite simply. That’s what I’m hinting at when I talk about a liquidity zone.

Examples and Case Studies

The short squeeze phenomenon is very common in the markets; it’s mainly due to a big loss of confidence that turns out to be unjustified, to a price perceived as too high, and to large short positions.

And then along comes some great news… Twitter, Elon Musk … ring a bell?!

Be careful, though: a short squeeze is above all a technical setup, and you shouldn’t expect Elon to wave his magic wand every week.

By the way, some estimates say Tesla was one of the most shorted stocks in the entire history of the markets. You know what came of it this year. The stock price went on a bull run like the ones we’re seeing in the crypto markets right now; I’ll let you imagine the result.

In fact, short and long squeezes happen very frequently in the BTC and crypto market. Watch the leverage you allow yourself to use; it has to stay in strict correlation with perfectly sound risk management!

Take a look at the price from early 2019 below. The price was contained in a range following a big loss of confidence. The shorts pile in there, hoping for a continuation of the downtrend.

However, the price then ripped so hard that we didn’t see it retest that level until the Black Thursday brought on by the Coronavirus crisis. The immediate recovery was mainly due to a significant imbalance on the short side.

The Captain’s Takeaway.

To sum up, a short squeeze happens when short positions get trapped. After which traders buy and automatically position themselves on the new trend. The result is a sudden rise.

Short squeezes will be all the more violent on markets that allow high leverage. When many traders use heavy leverage, the price tends to be especially volatile!

I sincerely hope this article has been useful in helping you understand the Short Squeeze phenomenon

To find all my trading & crypto courses, meet me on my blog — here’s hoping that in the future you’ll master anticipating a short squeeze!