A short squeeze is characterized by a rapid rise in the price of an asset, increased trading volume, and high volatility, which can result in significant losses for short traders. To reduce the risks of getting into a short-squeeze, stop-loss orders and hedging instruments should be used, as well as low leverage.

How does it happen?

One of the primary causes of the short squeeze is the dense accumulation of open short positions at a specific price level. As prices rise, market participants are forced to limit their risks and close unprofitable short positions.

Because an asset must be purchased to close a short position, a rise in its price only increases demand. This, in turn, raises the price even higher, increases losses for holders of short positions, and leads to mass liquidations.

The automated nature of modern exchange trading, possible panic, and increased volumes can result in massive price spikes of several tens of percent. Furthermore, in some cases, a short squeeze can cause an asset’s trading to halt.

A similar situation occurred on the Nasdaq exchange with Robinhood Market shares — due to volatility, trading of securities had to be halted three times.

Short squeeze examples

Short-squeeze is quite common in any market, including cryptocurrency, below are two examples.

GameStop

Members of the WallStreetBets subreddit discovered open short positions with hedge fund Melvin Capital on shares of GameStop (GME) in November 2020, which was in pre-bankruptcy.

To prevent the company from collapsing, network “activists” decided to use this information and began buying GME stock on the exchange. The movement grew massively, and GameStop’s stock price increased more than 20 times in less than a month.

According to the Wall Street Journal, the short-swap resulted in a 30% loss of all capital at Melvin Capital, and the aggregate loss of GME short position holders was $19.75 billion.

Celsius Network

In June 2022, due to extreme market conditions, cryptolending platform Celsius suspended withdrawals, exchanges, and transfers between accounts. All of this resulted in a significant decrease in the value of the platform’s native CEL token.

Using the social network Twitter, a group of enthusiasts decided to replicate 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 that the Celsius platform had suspended withdrawals, including CEL tokens. In addition, the company’s financial problems should have sparked 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.

How to protect from short squeeze?

Short-squeeze is a common occurrence in the cryptocurrency market due to the low liquidity of many crypto-assets, a lack of hedging instruments, and weak legal regulation. The following mechanisms can be used to reduce the risks of short-swaps:

Stop order: The easiest and most efficient method. It will keep your open short position from being completely liquidated and will save you from making emotional decisions.

Hedging: When traders open a short position, they hedge it with a reverse trade: if you open a short position, you can also open a long position (long) on the same asset. If the quotes fall short of the trader’s expectations, the hedge position will mitigate the loss.

Spot trades: Trading on the spot market eliminates any debt relationship between the trader and the platform, removing any liquidation risks. These trades are not intended to profit from an asset’s falling price, but they will protect against most risks, particularly for beginner traders.

Low Leverage: Traders frequently use high leverage, which increases the risk of financial losses. According to the Binance exchange, an average of 60% of futures trades were opened with 20x leverage in 2019, which is a high ratio. As Morgan Creek founder Mark Yusko put it, leverage “never makes a bad investment good, but it frequently makes a good investment bad.”

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