A short squeeze is a term used to describe the phenomenon in financial markets when a sharp rise in the price of an asset causes traders who previously sold to close their positions. A short squeeze occurs when sellers decide to cover their short positions, or those positions are closed automatically due to a stop-out. Thus, a short compression can feed itself. Fearing that the asset will continue moving up, traders close their short positions with the necessary buy orders. These buy orders move the asset price up. This fuels the buying fire, attracting more buyers and pushing the stock price even higher.
Typically, short squeezes occur because traders open a huge number of leveraged short positions. With leverage, traders accumulate a large volume of positions, several times larger than they would have been able to afford without leverage. By using leverage and large volumes, even a small price movement in the opposite direction can result in a stop-out.
Short squeezes occur in all financial markets, but they are most common in the stock market. Short sellers often focus on stocks that they believe are overvalued by the market. For example, Tesla Inc. (TSLA) has caught the attention of many investors with its innovative approach to producing and marketing electric cars. One part of the investors was betting on its potential and bought Tesla shares. Another part – short sellers that were betting big positions on its failure. At the beginning of 2019, more than 20% of the shares outstanding were in short positions. From late 2019 to early 2020, Tesla stock was up 400%. Short sellers failed, losing a total of about $8 billion.
Another example is the notorious stock of GameStop Corp. (GME), which has become a target for short sellers due to increased competition and declining mall attendance. The interest in short positions in these stocks was enormous and grew every day. Then in early 2021, rumors began to emerge that the company could return to profitability in a couple of years. This claim was also advertised on Reddit. In addition, major investors also took a long position in it. GameStop’s share price exploded due to the short position of large hedge funds that sold stocks to reduce losses.
In the forex market, squeezes occur both up and down. But mostly on lower timeframes and mostly during periods of high volatility. Therefore, in terms of time, the size of such squeezes is not comparable to those that occur in the stock market and can last for weeks.
How to identify an impending short squeeze?
One indicator is the percentage of short positions, which is the percentage of the total number of shares currently held by short sellers. If the percentage of the total number of shares currently sold short is significantly higher than the norm, the probability of a short squeeze is considered increasing.
From a technical point of view, an indicator of the impending squeeze is a long price accumulation without a significant price advance to one side. Such periods are also called flat or balanced when the price trades in a visual corridor. And the longer the price trades in such a corridor, the stronger the impulse movement on stop-losses and stop-outs to one side will be.
Volume traders can use tools such as delta analysis (the difference between the bid and ask). This allows you to determine how many traders sell and buy in the price corridor. As a rule of thumb, if a price corridor is oversubscribed to sellers, the squeeze will be up and vice versa.
In the chart below, in the accumulation zones, the preponderance of negative positions (negative delta) led to a sharp increase in price. In contrast, the preponderance of purchases (positive delta) led to a fall.
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