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The term ‘risk’ is one of the most widely used in the trading world. Betting on the success of any commodity is dangerous to some extent, but experienced traders will benefit regardless of market conditions with the right intuition. Shorting an asset is banking on its depreciation, and it entails borrowing the asset and selling it, only to repurchase it at a cheaper price and give the asset back. Benefit is the sum left over after deducting interest.
What is Short Selling?
Short selling is common practise that keeps both consumers and businesses on their toes. It is only worthwhile to keep an investment if it can be sold. Traders can even short a commodity if it seems to be overvalued. GameStop was recently reported as the most shorted business on the S&P 500, owing to market perception that it would not survive the coronavirus’s turn away from retail stores.
This holds true for cryptocurrencies as well. With regulators tightening KYC standards and restricting anonymous transfers, the sentiment around privacy tokens is very gloomy. Since mid-2020, the number of shorts on Monero, arguably the most popular privacy coin in the blockchain domain, has been increasing. According to Datamish, it actually has more shorts than longs, with the majority of them unhedged.
However, if the economy does not meet the trader’s forecast and the commodity increases in value, traders can rebuy in a frenzy in order to reduce their loses. In certain situations, particularly for cryptocurrencies, using a derivative contract to short an asset is far cheaper, and since these have an expiration deadline, traders are required to move fast.
What is A Short Squeeze?
During a rapid market movement, short-sellers will repurchase an asset in large numbers, generating leverage that drives the asset and its price even higher. This drives short-sellers out of the market, generally at a loss. After falling to about 6% of its all-time peak, GameStop’s stock started to climb in a short squeeze beginning in September 2020, increasing by more than 10x over the next few months. The short squeeze has a lot of strength. In 2008, a short squeeze increased Volkswagen stock by 5x in just two days, momentarily elevating the company to the top of the world’s most expensive list.
It arrives suddenly, without warning, and with no mercy. With an 18% short interest, Tesla’s 400% growth from late 2019 to early 2020 cost short-sellers over $8 billion. However, the slump in March returned $50 billion to their pockets in a matter of days. It’s a risky situation, and dealing with a tight squeeze needs both expertise and experience. You’re almost there if you’re reading this.
Is A Short Squeeze Good or Bad?
Regardless of how confident an investor is in an asset’s ability to depreciate, a short position can be easily washed out by anything as plain as a product launch or a positive news report. While these changes may be transient, if left unchecked, they may result in significant losses and even total liquidation.
What Causes A Short Squeeze?
A short squeeze forces short-sellers to re-enter the market, increasing the price and squeezing out more shorts. A short squeeze can also happen when there is an interruption of supply or excess demand for a commodity as a result of short sellers liquidating their positions.
Being trapped on the wrong side of a tight squeeze can be disastrous, and putting hard stops on all short places is a perfect way to avoid being stuck in one. This will help shield the money from unexpected price moves in any direction.
How to Predict A Short Squeeze?
It is almost impossible to reliably forecast a short squeeze any time, but by monitoring heavily shorted securities, traders can easily react when one happens. Holdings can be sold as momentum assets in these situations, but due to the increasingly volatile climate, it is critical to start tiny.
The first statistic to look at is an asset’s short interest ratio, which is calculated by dividing the number of shorts by the number of outstanding shares. It is calculated as a statistic, and the higher its worth, the more short-sellers there would be during a squeeze. A sharp rise or decline in short-term interest can be very revealing. Also a 10% rise in short interest means that one-tenth of the demand has gone short on the asset, which is a fair warning to explore further.
Bullish investors see a strong short interest as a chance to profit from the sudden momentum change. Short-sellers reduce liquidity during a crunch by rushing to offset borrowed money. Since short squeezes occur more often for smaller market cap securities, a supply bottleneck may easily emerge as a result of such situations.
By analysing whether the valuation is above its normal range, the short-interest ratio may be used to monitor investor sentiment. It is determined by dividing the total number of shorts by the asset’s average daily value. As this parameter falls below the lower end of the spectrum, it may indicate that an asset is overpriced or that short-sellers are exiting due to price stabilisation.
A increase above the range usually indicates that investors have turned bearish, and extremely high readings will predict an impending short squeeze. This will encourage speculative buyers to purchase even more of the asset, driving up the price even more.
Every Last Drop
Contrarian buyers, or investors who buy assets with a high level of short interest in order to profit from possible short squeezes, buy assets with a high level of short interest on a daily basis. Profiting during a squeeze is very appealing, but it comes with its own set of risks. Perhaps the shorts were right in their assessment of the asset’s valuation, and the asset’s sudden increase is temporary.
Active traders routinely witness heavily shorted assets entering only before the squeeze begins. Nonetheless, while there are several cases of securities that have been short squeezed as a result of high short interest, there are still assets of high short interest that have continued to sink in value.
High short interest does not always indicate a short squeeze, but rather because a considerable portion of the investor feels the commodity is overvalued. Investing in those assets purely on the basis of short interest is definitely a poor move, particularly when a large portion of the market believes it will decline in value. Trading high short interest securities, when paired with indications from other measures, can be extremely lucrative.
Find an asset with a short interest rate of 20% and a short interest ratio, or ‘days to cover,’ of 5. This means the short-sellers would have to wait five days to repurchase all of their sold stock. In the event that a surprise product launch or news release causes the asset’s price to rise, multiple short-sellers will be forced to liquidate their bets, with those who shorted the least suffering the most.
A Short Squeeze v.s. A Long Squeeze
In a similar way, a long squeeze happens when the value of an asset drops suddenly, increasing selling demand and squeezing longs out of the market to safeguard their portfolios. While the long squeeze is not as common as the short squeeze, it is much more applicable in smaller, less liquid markets with more determined and panicked buyers, resulting in higher volatility levels.
This is due to the fact that, while a short squeeze causes short sellers to liquidate, a long squeeze would create enough panic for long buyers to begin dumping. They have no underlying justification for sale and can be very short or very long based on a variety of factors. When the price sinks too low, short-term buyers usually bid up the price after getting the oversold warning.
When it comes to liquidity, it’s important to keep technical statistics like supply and demand in mind. Stocks that are aggressively rising are more vulnerable to long squeezes, particularly if the volume is very high. Investing in value is the only way to deal with these squeezes. Unless there was a more underlying explanation for the sell-off, undervalued assets would normally rebound.
With the emergence of digital trading platforms, bots can now easily enter low liquidity markets and benefit from both long and short squeezes. Large players can effectively exploit a low-market-cap commodity, creating a ripple effect that drives the price in any direction.
Short Squeezes in The Crypto Market
In June of last year, Bitcoin stunned the industry by skyrocketing from under $9,500 to a 4-month peak of nearly $10,400 in a single day. It triggered the most liquidations on BitMEX since October 2019 – worth a whopping $133 million. About $430 million in Bitcoin shorts is liquidated across all channels in less than 24 hours, with the majority of them happening within an hour of Bitcoin reaching $10,000.
Short squeezes occur as traders force an increase in demand over a period of limited availability. In low-liquidity markets, this will greatly boost leverage, because the greater the short selling, the quicker it is to drive short-sellers out of the market.
However, short squeezes can occur in any stock market, even more stable investments with high market capitalizations. Although Bitcoin does not have the greatest liquidity, particularly as compared to conventional stocks and bonds, BTC’s recent rise to about $40,000 has increased Bitcoin’s market capitalisation to more than $1 trillion.
Short squeezes occur often in cryptocurrency markets, most notably in Bitcoin markets. Any Bitcoin futures markets employ high leverage positions that can be liquidated despite comparatively minor price fluctuations. In competitive markets like bitcoins, the only approach to prevent getting liquidated is to limit the leverage and implement better risk control techniques.
As a result, short squeezes aren’t anything to be concerned with unless you’re short selling for trading purposes. A short squeeze is nothing more than a chance to prosper if you have the correct signs from multiple measures and oscillators paired with insight into the status of the commodity in question.