What Is a Short Squeeze and Why Does It Happen

In this post, we'll look at what a short squeeze is and how it affects the market. We'll also explore why it's important to understand the causes and consequences of a short squeeze before opening a short position.

What Is a Short?

A short, or short selling, is a type of trade that lets you bet on a price decline without directly holding the asset. Through shorting, traders can profit from falling prices or hedge assets they already hold.

However, shorting can be a very risky strategy. An asset's price can rise without limit, and a short squeeze can occur. A short squeeze refers to a situation in which an asset's price rises sharply, short positions are closed one after another, and the price climbs even higher.

What Is a Short Squeeze?

A short squeeze is a situation in which many short positions are closed in succession and the asset's price rises sharply. A short squeeze happens when a large number of traders have entered short positions.

People who open short positions place their bets expecting the asset's price to fall. But if the price breaks through a resistance level and rises sharply, automatic risk management tools such as a stop loss may be triggered. Or a liquidation may occur, closing the short position at a high price.

Why Short Squeezes Happen

Traders open shorts on assets whose prices they expect to fall. However, if the asset's price rises on the back of positive news, strong earnings, or a sudden surge in buying, a short squeeze can occur.

A short squeeze happens when buying pressure increases sharply while a significant number of short positions exist, and that buying pressure forces short positions to close one after another. As a result, even more shorts have to exit their positions in an instant. This can push the asset's price even higher.

Short Squeeze Example 1. Tesla

The most famous example of a short squeeze is Tesla (TSLA) stock. At the time, negative opinions about Tesla and the view that its stock was overvalued had led to a huge number of short positions being opened on Tesla.

• From late 2019 to early 2020, Tesla's stock price soared by as much as 400%. This caused a significant short squeeze, resulting in total losses of $8 billion.
• In early March 2020, Tesla's stock price fell sharply due to the COVID pandemic. But the stock eventually rebounded, and traders who shorted Tesla lost more than $40 billion in total over the course of 2020.

Short Squeeze Example 2. GameStop

GameStop's stock price swings are another well-known example of a short squeeze. After COVID-19 broke out, many traders and investors began betting on a decline in GameStop (GME) stock.

The reason was that they expected consumers to be unable to visit stores because of COVID, foot traffic at GameStop's physical stores to drop, and the company to eventually go bankrupt. As a result, a huge number of short traders piled into GameStop. At the time, short interest grew so much that it exceeded 100% of the shares issued.

However, Michael Burry, head of the hedge fund Scion Capital, and Ryan Cohen put forward the view that GameStop would not go under and could return to profitability within a few years. This led them to start taking long positions. From late 2020, many investors began buying the stock, and retail investors bought up enormous amounts of shares and call options.

As a result, GameStop's stock price began to rise sharply, and traders and hedge funds that had shorted GameStop rushed to close their positions. This triggered a short squeeze, and GameStop's stock price, which had been under $5 per share, climbed to $325 in just one month.

Short Squeeze Example 3. Bitcoin

Short squeezes also happen frequently in the Bitcoin derivatives market. Because the crypto derivatives market allows very high leverage, positions can be closed or liquidated even by small price movements. That's why it's always important to have a solid risk management strategy in place when using leverage.

In early 2019, many people were betting on Bitcoin falling. Bitcoin's price, which had been stuck in a range for a long time, rose sharply as a short squeeze took place.

Wrapping Up

A short squeeze occurs when traders who entered shorts have to close them because of a sharp price rise, and it ultimately leads to a rapid increase in the asset's price.

Short squeezes can happen in markets where sentiment has been overly negative or where leverage is large, and they can cause enormous volatility and rising asset prices.

Anyone looking to open a short position must understand the concept and effects of a short squeeze. Otherwise, you could suffer heavy losses.