What is a short squeeze, and how to avoid losses ?

Opening a short position allows a trader to make money on a falling price. It is a relatively common method of making money in a bear market. However, it is associated with certain risks. One of these risks is the chance of getting into a short squeeze.

A short squeeze is a sharp rise in the price of an asset in which short traders are forced to close their positions en masse. Since closing a short position implies buying back the asset at the current price, this causes a cascading effect of buy orders that push the price even higher, closing the following short positions.

A prerequisite for a short squeeze may be a significant advantage of short positions over long positions and a prolonged asset price fall, attracting many short traders. In this case, the ratio of long and short positions is a valuable tool for traders who want to avoid losses.

The more open shorts, the easier it is to drive sellers into this trap. In other words, the more liquidity in the market, the greater the volume of forced buy orders, and the more substantial the price increase.

Short squeeze risk usually occurs when many stop losses are triggered at a firm price level, pushing the price higher. Some traders who weren't out due to stop loss exit trades manually to avoid further losses, thereby increasing their buying volume.

Short Squeeze Examples

1. GameStop

One relatively recent example is the GameStop short squeeze. Their stocks have been in decline for a long time, and many traders and large hedge funds have shorted the asset.

However, some investors, including Bloomberg reporter Brandon Kochkodin and the Reddit community WallStreetBets, have been vocal about the company's stock being grossly undervalued. Within a short time, they managed to gather many supporters around them.

A whole army of small investors was buying GME, pushing the price up. A massive number of short positions were forcibly closed, causing further cascading effects. At a particular moment, the GME price reached $483, despite the fact that the company's shares were trading near the $17 mark at the beginning of the month. The short traders lost billions of dollars.

Short squeeze GME. Source: Tradingview

2. Celsius (CEL)

Crypto lending platform Celsius filed for bankruptcy this summer. On June 12, the company halted withdrawal services. Then the price of the token fell to $0.15. The platform issues have created a great opportunity to short the coin that many traders have taken advantage of.

Then the community, taught by the experience of Game Stop, decided to hold another “event” under the tag #CelShortSqueeze. It is noteworthy that the founders of Celcius approved this idea and supported it in every possible way. Already in August, CEL was traded at nearly $4.50. The token failed to keep its highs and quickly returned to levels below the one dollar.

Short squeeze CEL. Source: Tradingview

How to protect yourself from losses during a short squeeze?

1. Stop loss. Experienced traders know that placing stops is necessary in most cases, especially at night. This tool helps limit losses and avoid getting stuck in a losing trade in a short squeeze.
2. Hedging. If a trader is considering a short squeeze, he can place an order to buy the same asset at the level where the stop should have been located instead of placing a stop loss. In this case, he will profit from the continuation of the upward movement, which can cover the loss from the previous transaction. Hedging can also involve the trader buying the coin they are shorting on the spot.
3. Spot trading. Although spot trading does not involve making money on price declines, it is much less risky than derivatives trading. When trading short squeezes on spot, you can earn but not lose. (Unless, of course, you do not buy on high marks).

Conclusion

Although trading short squeezes can be rewarding, traders often lose their money in such situations. But, of course, long-term holders get the greatest pleasure from short squeezes. To pick the right time to enter a position, it is advisable to monitor coins that are being shorted actively.