Since the cryptocurrency markets have borrowed a lot of concepts from traditional finance and the stock market, you shouldn't be surprised to come across terms like short selling or short squeezes.
Not everyone is familiar with how trading works, so in today's article, we're going to explore trading strategies like short selling or shorting and discuss the crypto short squeeze phenomenon.
What is short selling?
Trading short enables investors to benefit from a declining asset's price. It's a fairly popular strategy for hedging current holdings, managing downside risks, or expressing a bearish perspective on the market. Short-selling a cryptocurrency means planning to purchase it back when the price drops.
A short position enable traders to benefit even during a bear market when prices decrease. The cryptocurrency being exchanged doesn't have to be owned by the traders. Margin trading fuels short selling. In this scenario, traders open a short position using money borrowed from an exchange and then close the position by paying the exchange. Most cryptocurrency exchanges that provide margin trading have stop-loss mechanisms, which reduce the loss suffered by short sellers.
Short sellers should know that they are using this strategy at their own risk. The main two risks involved are the fact that there is no upper limit for the price of an asset and the possibility that a short squeeze happens.
What is a short squeeze?
A short squeeze, also known as a bear squeeze, occurs when the price of an asset rises quickly, causing short sellers to close out their positions by repurchasing their tokens at an exorbitant price.
A short squeeze is frequently referred to as a manipulation event in crypto markets since the price action deviates from the asset's predicted trajectory and often entails the partially coordinated activities of numerous traders.
Many short sellers experience huge losses during a short squeeze.
How do crypto short squeezes work?
Now that we've seen how short squeezes happen, you're probably wondering, "how does a short squeeze work?"
Typically, a short seller borrows and sells the number of tokens they wish to short when they open their position. When they decide to sell their tokens, they buy the same number they borrowed initially and give the tokens back to the lender to pay off their debt. They then keep the profit earned from the price differential between the original purchase price and the price at which they repurchased their borrowed tokens (minus trading and funding fees). Such a trade is considered successful.
However, if the crypto or stock price moves against their trades, short sellers are forced to buy stocks or cryptocurrencies at a much higher price than what they sold them at. This could lead to a significant loss for many investors.
A dead giveaway of a short squeeze if there are more short positions than long positions on the market.
How to trade short squeezes
If you wish to participate in a short squeeze, some tips for trading cryptocurrencies in a short position could be helpful. However, please be aware that they do not constitute investment advice and that your own research should back up any decision you might take. It's also imperative to understand that the crypto market is extremely volatile, and shorting is a high-risk strategy.
- Pay attention to short squeezes. They happen suddenly and cause the share price to spike dramatically, which could cause you or your company to lose money.
- When prices start to change, more buyers become aware of the situation, which amplifies the buying and may cause the stock or crypto tokens to explode in price.
- Always apply hard brakes to your short positions to prevent becoming caught in a short squeeze, especially if you want to hold them overnight.
- Keep in mind that not all attempts to buy back shorted shares are motivated by positive news.
- In the stock market, for example, the prime broker (the unit of a bank in charge of stock lending) requests the return of the borrowed shares, and there can be a rush.
How to Avoid Getting Caught Up in a Short Squeeze
Only a few traders are aware of the evolving circumstances and can sell their position before the market swings against them. Other short sellers get caught up in a short squeeze frequently.
Thankfully, there is a large number of preventative measures you can take to protect yourself from a short squeeze.
Avoid exchanges with low liquidity
Short squeezes occur way more often on exchanges with insufficient liquidity. If you avoid these platforms, you can reduce your chances of being caught by the initial volume attack that starts a cascade of liquidations.
Always choose well-known and established crypto exchanges that have enough liquidity.
Don’t use high leverages
Generally speaking, short squeezes are brief events that last only a few hours or days at most.
By avoiding high leverage, you can limit the likelihood of your short position being pushed over its liquidation threshold, protecting your solvency until the short squeeze inevitably fails.
Be aware of manipulation attempts
A short squeeze frequently involves obvious rallying activities on social media, primarily on YouTube, Twitter, and Reddit, where participants want to intensify the squeeze by enticing traders to go long.
You can find out if there is a continuing campaign by searching "short squeeze" and the asset's name on popular social media channels.
Try to track short activity
The primary target of a short squeeze is represented by an open market with a high ratio of short to long traders.
You can always stay in the loop by keeping track of the short interest ratio (shares short divided by average daily trading volume). A high short-interest ratio means there's an increased risk for a short squeeze.
Don't chase your losses
When short traders try to profit from a short position, they risk losing money if they are forced to buy back their tokens at a price higher than what it initially was. If that happens, it might not be a good idea to try to recover those losses.
Even though most crypto short squeezes are transient, some are incredibly persistent and have the power to drive assets to incredible heights. It can be challenging to forecast the top, and doing it incorrectly could lead to substantial losses.
Short squeeze examples
When it comes to stocks, short squeezes happen quite often. A low perception of a company, a high stock price, and a large number of short positions typically characterize it. If, for example, some unexpectedly positive news surfaces, new buyers and other investors are compelled to buy, which raises the stock's price. A short squeeze is still more of a technical pattern than a fundamental occurrence, though.
For example, the electric vehicles company Tesla, whose stock is called TSLA, has the most shares sold short in history. Nonetheless, the price has experienced several substantial increases, potentially trapping many short sellers.
Short squeezes are also fairly widespread in the crypto markets, most notably in the Bitcoin markets. High-leverage positions are used in the Bitcoin derivatives markets, and these can be trapped or liquidated with only little price changes. As a result, there are frequently short- and long-squeeze situations in the Bitcoin markets.
If you want to avoid becoming liquidated or trapped in such moves, carefully assess the amount of leverage you're utilizing. You should also implement an effective risk management strategy.
Let's recap a few of the things we've discussed today. Since cryptocurrency prices are highly volatile, short squeezes cannot be avoided. Considering that an equivalent spike in trading volume usually accompanies a short squeeze, panicked short sellers create a dramatic price rise.
Also, investors should keep in mind that the larger the short interest is, the easier short sellers get trapped and find themselves forced to close their positions. To put it in another way, the more liquidity there is to trap, the greater the spike in volatility may be due to a bear squeeze.
Before you take a short position, be sure you are aware of the consequences of short squeezes. Short selling carries earnings and losses in equal measure.
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