Top Trend Indicators That Tell You the Direction of the Trend

Sometimes the market brings surprises to those who work in it. A rate, which has not been characterized by impulsive movements and has been moving quietly up or down, suddenly bursts like a rocket. It rises in price at breakneck speed, knocking down all orders on its way and throwing unlucky players out of the market, at some point it stops and just as rapidly comes back to the place or level close to the point of takeoff.

This impulsive surge has its own name in the stock market - a short squeeze. The danger, especially for intraday traders and scalpers, is that it is almost impossible to find it out with technical or fundamental analysis: it is like a bolt from the blue.

In this article, we will learn what the short squeeze is and how you can benefit from it.

What Does Short Squeeze Mean?

Usually, such formation appears in a relatively calm market with almost no prerequisites. And the price bursts are caused by lovers of short positions, who earn on speculative moves.

To understand what is a short squeeze on the market, it is necessary to understand the nature of a short position. When the trader sells an asset they do not actually own, the following happens: the broker lends the securities with the requirement that on the speculator's account there must be the amount of funds proportional to the price of borrowed assets at the current rate. The trader sells the stocks borrowed from the broker in the hope that they will fall in value. If it happens, all of the sold assets are repurchased at a lower price and returned to the broker as repayment of the debt. And the difference between the sale price and the closing price stays in the short's account (that's what they call those who open short positions).

If the price after opening the sale begins to rise, the trader runs the risk of closing the position with a loss, because they will have to redeem the stock at a higher price than they sold it, paying the difference out of their own pocket. In case the stock has grown so much that there are not enough funds on the trader's account to cover the margin call, the trade is closed by a compulsory margin call.

How Shortists Become the Cause of the Short Squeeze

If the formation in question is a sharp rise in price, what does shorting have to do with it? How does this help answer the question of what is a short squeeze in trading? In fact, traders placing short positions are really a major factor in the occurrence of short squeezes in the markets. Short squeezes are especially common where large volumes of short positions are present. The hopes of speculative traders are focused on assets that are subject to regular significant corrections.

A future short squeeze originates in the following way: the traders believe the asset is overbought enough and the price is about to go down, so they begin entering short positions, provoking an increase in the volume of shorts. Professional traders with large capital see that a high volume of short positions is formed in this asset, and they buy a lot of shares to change the situation. Shortists understand that the forecast did not come true, the asset begins to grow, bringing losses, and in a panic close their positions to minimize losses. This pushes the quotes to even more rapid growth. Positions of players, who hoped for a reversal and did not close, are knocked out by a margin call, which throws the price even higher.

Those who initially caused this chain reaction to waiting until the quote reaches a value unattractive to the demand for this asset, and begin securing gains by selling their assets at the maximum price. After that, as a rule, the asset falls at practically the same rate as it was growing. The chart below shows what a short squeeze looks like in trading.

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In the chart, you can see the fall in the price after a long consolidation. When the price reversed and went up, the volume of short positions increased at the level because the shortists thought the pullback was over and the price would go further down. But the big players didn't let it happen, and the same thing happened as stated above.

Can You Predict the Appearance of a Short Squeeze?

Because this pattern appears at the most unexpected times and in the most unexpected places, it is virtually impossible to predict its next appearance. It can appear, breaking all the dogmas of technical analysis, without any fundamental basis. But according to some attributes, it is still possible to identify the short squeeze.

It only appears in the assets with high liquidity and the possibility of short positions.

It most often occurs after the breakout of the long price corridors and during the long trends, as well as at the price extremums.

There is an active buying of large volumes in the Market Depth and a price acceleration on the chart.

After the quotes slow down and large sell lots start to disappear in the Market Depth, there will be a sharp reversal and a fall.

The occurrence of the short squeeze can occur in the absence of any fundamental data: in an empty space or during the release of some minor news.

Short Squeeze Examples

A short squeeze is quite common in any market, including cryptocurrency. Let us have a look at several examples.

GameStop

In November 2020, members of the WallStreetBets subreddit discovered open short positions with hedge fund Melvin Capital on shares of GameStop (GME), a store chain that was in pre-bankruptcy.

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Network "activists" decided to use this information and began buying GME stock on the exchange to keep the company from collapsing. The movement took on a mass character, and in less than a month the GameStop quotes rose by more than 20 times.

The Wall Street Journal estimates that this short-squeeze caused Melvin Capital to lose 30% of its total capital, and the aggregate loss of GME short position holders was $19.75 billion.

Celsius Network

In June 2022, crypto landing platform Celsius suspended withdrawals, exchanges, and transfers between accounts due to extreme market conditions. All of this led to a severe drop in the value of the platform's native CEL token.

A group of enthusiasts, using the social network Twitter, decided to repeat an operation similar to the GameStop short-squeeze. The movement was organized around the hashtag #CELShortSqueeze.

According to Decrypt, the main argument for the short-squeeze was the fact that the Celsius platform suspended withdrawals, including CEL tokens. In addition to that, the company's financial problems were supposed to generate interest in shorts from traders and large companies.

The essence of the "operation" was to buy CEL tokens on the exchange and withdraw them into cold wallets so that no one could use those tokens to sell. As a result, on June 19-21, 2022, the price of CEL nearly tripled, from $0.55 to $1.5.

What Causes a Strong Price Rise When Shortists Close Their Positions?

The fact is that to close a short you need to buy (buy back) your position. As a result, closing the results of the short in a huge amount of buying, and the market reacts to this process instantly. There is a sharp jump, followed by the same sharp fall, and the final price, depending on the situation, maybe even below the opening level of the trading session. The reason for it is the absence of a real buyer and the ejection of the "crowd" of shorts from the market. Exactly this way the market may reverse before the sharp fall of quotes, or short squeeze.

The reason for a short squeeze is usually unclear - a sharp rise can arise either because of a major positive informational vector or in its absence. Shortists are not too welcomed by big players. There are situations when players, we can say, are driven into a corner. The big market players actively buy up stocks, thus forcing the shortists to close their positions. Such actions are strictly prohibited, but nevertheless, they occur rather frequently - it is extremely difficult to prove such manipulations. Basically, a short squeeze allows big players to sell shares at the peak value and get a large gain. It is not for nothing that short squeezers are called market fuel.

What Short Squeeze Means for the Long Term Investor

The short squeeze is a concept from the world of traders. For a long-term investor who regularly buys stocks on a horizon of several decades, such rallies cannot be a significant cause of loss. But you can try to turn the situation to your advantage. Namely, you can temporarily close your position at the peak and reopen it when the situation stabilizes.

In my opinion, this approach has significant drawbacks. You need to remember that you may have to pay tax on these transactions. And this in itself will reduce their success rate. In addition, to take advantage of such a short-term surge, you need to constantly monitor the market. It's hard to call it passive investing anymore.

Short Squeeze and Passive Investing

There is an important reason to know what a short squeeze is. It lies in the fact that you should be able to distinguish between a technical bounce and a rise in quotes due to fundamentals. By understanding the mechanism of this phenomenon, you will not make the mistake of buying a rising stock at a local high. Inexperienced players can make such a move, mistaking the price jump for the beginning of a rally.

At the first moment, it is not easy even for an experienced investor to distinguish a short squeeze from a real reversal. If you see that the price went up by more than 6-8% in the background of minor news, do not rush to increase your position. This is a likely sign that a major player has become active.

Understanding the nature of the short squeeze would protect you not only from reckless buying but also from panic selling. A sharp rise is followed by an equally rapid fall, which is actively covered in the media. Journalists, interested in hype, often describe it as a critical loss of capitalization and collapse of quotes.

At such a moment, it is important to follow the developed strategy and understand that this situation is a correction after the growth, which was not justified by fundamental reasons. It will not develop further and will not lead to the issuer's bankruptcy. Short-term price fluctuations will not affect the investor in any way if they continue to hold their assets. If there is a sharp drop in the price below the value the asset had before the jump, it can be used to build up a position. However, such a move should not contradict your original trading strategy.

How to Protect Yourself Against Short Squeeze

A short squeeze is a frequent phenomenon in the cryptocurrency market because of the low liquidity of many crypto assets, lack of hedging instruments, and weak legal regulation. The following mechanisms can be used to reduce the risks of short squeeze:

Stop orders. The simplest and most effective way. It will keep your open short position from being completely liquidated, and save you from making emotional decisions.

Hedging. When opening a short position, traders hedge it with a reverse trade: if you open a short, you can open a long position (long) on the same asset. If the quotes go against the trader's expectations, the hedge position will reduce the loss.

Spot trades. Trading on the spot market excludes any debt relationship between the trader and the platform - this removes any liquidation risks. These trades are not designed to capitalize on the falling price of an asset, but they will protect against most risks, especially for beginner traders.

Low leverage. Very often traders use high leverage, which multiplies the risk of financial losses.

How Can You Benefit From This Situation?

First, we should always remember the possibility of such an impulse, especially if the price has been in a sideways trend for a long time. You can mistake a sharp rise in price for a new uptrend, buy stocks and end up either making a loss or having a drawdown.

Second, you have to be able to tell the difference between a real rise in value, which is based on fundamentals, and a similar technical jump. This process can be difficult to track, even for experienced investors. Therefore, it is important to stick to your original trading strategy so as not to make a mistake and incur heavy losses.

A short squeeze can be an opportunity to earn a substantial income: for example, you can enter a position on a bounce and close the short at the moment when the decline begins to fade. However, such actions are quite risky. For the long-term investor, it is better to watch the situation from the sidelines.

Conclusion

A short squeeze is a sharp spike in quotes, leading to the forced closing of short positions. The traders who are in them are then forced to buy the stock, pushing the price even higher. Such a situation is almost always due to the actions of a big player and has no fundamental grounds. Such a rise is bound to be followed by a decline. For the longer-term investor, getting out of a position at the highs and reopening it when it stabilizes is one way to generate additional earnings. But such actions are always risky.

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