Nowadays, trading has become routine for many traders so that their habitual actions leave no room for curiosity. But this is not the way it should be. Behind each function, strategy, or step of a market player, there is always a well-developed algorithm that has been used for decades. These algorithms have their history and peculiarities. Today, we will discuss one of such trading concepts - the short squeeze - and the reason behind its popularity.

What is short squeeze?

To put it simply, a short squeeze is a rapid rise in stock prices triggered by an unexpected increase of short selling of a stock. To better understand this trading phenomenon, we will discuss an example below when a group of day traders* created a short squeeze in early 2021 and boosted the price of some stocks by as much as 1,000%!

To get a deeper insight into the concept, let’s discuss what a “long” and a “short” position means. When opening a long position, investors buy an asset, hoping that its value will increase over time. When opening a short position, investors sell an asset as they believe it will drop in price in the future.

In the case of a short squeeze, we are going to talk about short positions. When trading short, the investor borrows a certain number of shares from a broker and then later sells them to buyers. If the stock value declines over time, the investor buys these shares back at a lower price and returns them to the intermediary firm. This is how investors can make profit from a fall in the asset price.

Short positions are mainly opened by large institutional investors. However, any retail trader can also try his/her hand at this trading strategy. This is usually done with the help of CFDs*, a type of derivatives based on an underlying asset.

After discussing the basic idea of short positions, we can now give a full definition of a short squeeze. It is such a condition when the price of a stock unexpectedly jumps, thus giving short sellers a hard time. The sellers need to close their short trades as quickly as possible to minimize losses and purchase securities instead to be able to return them to the broker. As a result, investors are racing to close out their short positions, which accelerates the price of the asset.

To trade a short squeeze, you need to have access to global markets. The easiest and the most reliable way to do this is to use the MetaTrader 4 trading platform available for download on the InstaForex website. There, you can trade CFDs on securities, indices, commodities, currency pairs, and more.

*Day traders are traders who open positions only during the day and close all of them by the end of the session.

*CFDs (contracts for difference) are affordable derivative contracts that allow market participants to trade various financial instruments by speculating on the price movements of the underlying asset or security.

The concept of a short squeeze is not limited to any specific market. It can happen to any type of asset, including precious metals, commodities, shares, etc.

Why short squeezes happen

There are a number of factors that can trigger a short squeeze. Actually, the excess of short positions in the market most often causes this condition. Thus, the longer the market is falling, the higher the likelihood is that the number of sellers will exceed the number of buyers. But what are the fundamental reasons for such a phenomenon? Let’s find out together.

1. Important news

First of all, this is the news of the companies listed on the exchange. When the stock price of a particular company declines, sellers rush to open short positions to cash in on the price fall. However, if the company reports better-than-expected earnings, for example, investors change their minds and close positions. This can be the beginning of a short squeeze.

Secondly, macroeconomic news can be another reason for it. Thus, a significant change in the monetary policy of a central bank can prompt the start of a short squeeze in the foreign exchange market.

For example, if a central bank decides to change the key rate and releases a positive outlook for future economic development, traders are likely to close their sell orders simultaneously. This, in turn, pushes prices higher as traders are racing to buy currency to close short positions in the market.

2. Technical factors

When an asset has been holding in the bear market for some time, traders tend to move their stop loss orders* lower. This creates some kind of synchronicity: investors place the stop loss lower in parallel with the market downtrend. This way, traders try to secure profits in case the market moves in the opposite direction.

When stop losses of most investors are located at about the same level, the release of important news can trigger them at once. Such active execution of orders of short sellers spurs high activity in buyers which results in a short squeeze.

3. Pressure from buyers

Pressure from buyers of securities is fairly new in the market. It happens thanks to traders who share their ideas on the Net. An army of supporters of a certain idea join to create a short squeeze for a particular company whose stock has been heavily shorted. As a result of such a massive attack, sellers have to exit their short positions and open long ones, thus causing a dramatic jump in prices.

This is exactly what happened in the market in early 2021. Back then, Reddit traders were able to act all together to orchestrate a short squeeze for US video game retailer GameStop whose stock was mostly shorted. As a result of this coordinated action, the company’s shares soared by more than 1,000%, bringing chaos to many hedge funds.*

Encouraged by the success of Reddit users, retail traders decided to organize the so-called “silver squeeze.” Find out what happened next on the InstaForex Analysis and Reviews page.

*A stop loss is a type of an order set by a trader to limit potential losses in case the market moves against the open trading position.

*A hedge fund is an investment fund that aims to maximize returns with given risks or to minimize risks for reaching the targeted return.

Conclusion

You may ask then, “How do I use this knowledge in my day-to-day trading and investing?” Firstly, understanding the principles of a short squeeze helps you avoid losses when facing it. Sometimes traders take upward momentum in the market as a new bullish trend. So, they start buying the asset near the local highs, betting on its medium-term growth potential. But when the price pulls back to the downside, traders incur losses. This leaves few options for traders to maneuver: they can either close positions with a loss or wait for a better price to sell at.

If this is not your scenario, we advise you to stand by without taking part in this market event. But if you are a happy owner of a security that is approaching a short squeeze, consider taking profit when the asset reaches an attractive price level. Most likely, you will have a chance to reopen this position under more favorable conditions as soon as the pullback ends.