For some traders, a short squeeze can be a golden opportunity to make a profit. However, for some traders, a short squeeze actually becomes a disaster that brings losses. Actually, what is a short squeeze? How to take advantage of it or avoid it? Find complete answers through the following article.
Article Summary
📈 A short squeeze is a situation where crypto prices rise sharply because many short sellers are forced to exit their positions to avoid larger losses.
🔁 Short sellers close their positions by making purchases which can push the price higher. This increase could trigger other short sellers to do the same and attract new buyers.
🤑 If you have the right timing, traders can profit from a short squeeze by taking a long position on an asset with a high short position.
🚨 To avoid the risk of a short squeeze, traders should make transactions on exchanges with high liquidity, avoid using high leverage, and monitor the long/short ratio.
A glance at Short Selling
Before understanding the short squeeze phenomenon, it is important to understand the concept of short-selling or known as shorting. It is the act of borrowing a crypto asset with the assumption that its price will fall and selling it, then buying it back at a lower price to return it to the lender. Shorters gain profits from the difference between the selling price and the lower buying price.
The profit calculation simulation is quite simple. Take the initial selling price (at the highest price) minus the repurchase price (at the lowest price).
For example, a short seller borrows 1 ETH at $3,500 and sells it immediately. Then ETH drops to $2,500, and short sellers buy it back and return it to the lender. So, the profit earned is $1,000.
The risk of short selling is that when asset prices increase, short-sellers will start to experience losses. The higher the price increase, the greater the loss. Apart from that, the risk can also be higher when short-sellers use the leverage feature.
What is a Short Squeeze?
Short squeeze is a term used when the price of a crypto rises sharply because many short sellers are forced out of their positions. Short sellers close their positions either due to the use of stop-loss or liquidation (for margin and futures). Not infrequently, they also close their positions manually to avoid bigger losses.
The way short sellers close their positions is by buying. However, a short squeeze can often have a snowball effect. When a group of short sellers close their positions, the price of the asset will creep up. When prices start to rise, it is possible that other short sellers will follow the same steps.
If so, a snowball effect will be created. The more the price rises, the more short sellers are forced to close their positions. Buying actions that occur continuously will further push prices up. At the same time, the momentum of the price increase will attract investors or traders who have not yet taken a position to seek their fortune. The snowball effect is getting bigger and bigger.
Source: The Moutley Fool
The opposite of a short squeeze is a long squeeze. It is a term that refers to the same effect when a long position is trapped by selling pressure. The impact was that prices experienced a sharp decline.
How Short Squeeze Works
As already mentioned, a short squeeze occurs when short sellers have to close their positions, either by stop loss, liquidation, or closing their positions manually. When the price of the asset they are short rises, the short seller is forced to buy the asset at a higher price than before.
The cause of a short squeeze can actually come from anything. Starting from updates on a blockchain to pure speculation by market players. The most important factor causing a short squeeze is an imbalance between demand and supply. A significant spike in demand can cause a significant price increase.
A short squeeze itself can occur in all financial markets, allowing traders to short. Meanwhile, if the financial market does not have the opportunity to short, it can actually create a large price bubble. This is because there is no way to bet that the asset price will fall, as a result the price will actually rise for a long period of time.
Example of Short Squeeze
The majority of large-cap cryptocurrencies have experienced a short squeeze at least once. With high crypto volatility, the practice of short squeezes is something that is quite natural, but is often disguised as general price movements. It will be found more when the market is bearish as the shorting ratio is greater.
One example of a short squeeze occurred in the Celsius token (CEL). In July 2022, Celsius filed for bankruptcy. This condition should be a negative sentiment as Celsius' fundamentals worsen. Seeing the opportunity for correction, traders then take shorting positions.
CEL price movement during before and after the short squeeze. Source: CoinMarketCap
However, the price of the CEL token actually skyrocketed from $0.77 on the day of the bankruptcy announcement to $4.30 a month later. Given the poor fundamentals, after the short squeeze, the CEL token price fell again. The short squeeze led to massive liquidations for short sellers.
The stock market is also inseparable from the short squeeze phenomenon. In mid-2019, Tesla announced that it would produce electric cars. Many market players are betting that Tesla will fail and its shares will fall. It turns out that Tesla shares actually rose more than 400%, causing liquidations of more than $40 billion throughout 2020.
How to Identify a Short Squeeze One of the visible signs before a short squeeze occurs is that the short position is more dominant than the long position. If there are more short positions than long positions, that means there is more liquidity to trigger a short squeeze.
It is not surprising that many then use the long/short ratio as a way to identify a short squeeze through market sentiment. Below is an example of Coinglass' long/short ratio.
Source: coinglass.
This ratio refers to the active buying volume to the active selling volume in a certain time period. It can reflect market sentiment in the short term. If the active buying volume is high, then it indicates bullish sentiment. Meanwhile, if the active selling volume is high, it indicates bearish sentiment because many traders are shorting.
How to Avoid a Short Squeeze A short squeeze is a movement that is deemed not to be sustainable. This makes many traders immediately take profits at the first opportunity, which in the end will reduce the power of the squeeze to last longer.
The following are some tips to avoid a short squeeze:
- Choose an exchange with high liquidity. Short squeezes can more easily occur and be manipulated on exchanges with limited liquidity. By avoiding these exchanges, you can minimize exposure to initial volume attacks that trigger liquidation.
- Don't use too high leverage. In some cases, a short squeeze can occur in just a few hours or days. By avoiding using high leverage, you can keep your position outside the liquidation zone when a short squeeze occurs.
- Observe shorting activity. Markets with a higher ratio of shorts to longs are more prone to short squeezes. Pay attention to the short interest ratio (short interest / daily trading volume). The higher the number, the higher the risk of a short squeeze.
An increase or decrease in short interest can be a sign of a shift in market sentiment. For example, a 10% increase in short interest indicates that 1/10 of market participants have shorted the asset.
How to Trade During a Short Squeeze
A high price increase makes a short squeeze an opportunity to gain maximum profit. However, don't forget that the risks are no less high. Therefore, traders must understand how it works, the causes of its occurrence, risk mitigation, and a clear trading strategy for trading when a short squeeze occurs.One way of trading is to look for crypto with high short interest to look for the potential for a short squeeze. However, remember, there is always a reason behind high short interest in a crypto, for example a poor fundamental outlook.
When the crypto shows signs of increasing prices and has good momentum, traders can place a long position and hope that a short squeeze occurs. In this strategy, the right entry point is needed, namely before or in the initial phase when the short squeeze occurs. Then sell it when the price has risen sharply.
Beware of periods of short squeeze. The longer it lasts, the greater the risk of losing strength and turning around.
Meanwhile, for traders or investors who already own assets that are experiencing a short squeeze, this period is an opportunity to exit their position. Especially if the asset has been in a decline phase for a long time.
Conclusion
Short squeeze is a phenomenon where the price of an asset experiences a sharp increase. This is caused by many short sellers who are forced to close their positions by making purchases. The more buying action, the more sharply the price will rise. Moreover, if the momentum of the price increase can trigger investors or traders who have not yet taken a position to make purchases.Short squeeze can be a promising trading strategy thanks to the high potential profits that can be obtained. However, the high rewards that can be obtained will always be commensurate with the potential risks. Identifying when a short squeeze occurs and how long it lasts is not easy. Indicators such as the long/short ratio can be used as a tool to identify short squeezes.