A short squeeze is a share market phenomenon that affects investors and traders who have taken action based on the belief that an asset (which can be a stock or Crypto) will decline but it increases instead. It’s fascinating, isn’t it?

Let’s quickly have a look at this phenomenon and learn the basics of it in this blog!

What is a short squeeze in Crypto?

A short squeeze, also referred to as a bear squeeze, occurs when the price of an asset rises quickly, causing short sellers to close out their positions by repurchasing their tokens at an inflated rate.

A short squeeze is frequently referred to be a market manipulation incident in the Crypto market since the price action often deviates from the asset’s predicted trajectory and frequently includes the partially coordinated actions of numerous traders.

Short squeezes might give amazing business opportunities for some people. Others, however, may find them to be financially disastrous because they can disrupt even the most foresighted short-term strategies.

How does short squeeze work?

Let’s divide the working of short squeeze into two stages to understand better how it functions. The first stage, in short selling, is to sell the stock, and the second (obligatory) step is to repurchase the borrowed stock and give it to the original owner.

Let’s take an example where ABC stock has been making waves on the stock market, causing investors to buy the stock due to its strong performance and their anticipation that it will rise further. But, contrarily, it has also piqued the interest of short sellers, who believe that ABC’s stock value is only temporarily on the rise and that it will soon fall.

In order to execute this trade, short sellers will borrow shares of ABC from their brokerage to sell the stock initially. If all goes according to plan and the price of ABC’s stock drops, they will then purchase the stock back at a lower price and profit.

Short sellers become buyers when they participate in the second phase and buy back ABC stock. Therefore, the share price of ABC stock will rise as long as buyers are buying it and short sellers (who change into purchasers in the second phase) are repurchasing it. As a result, not only will the share price of ABC rise, but other short sellers will start to worry because ABC’s stock is steadily rising rather than falling. More short sellers will hurry to buy back ABC stock, as a result, closing their positions and limiting significant loss. Due to the ABC stock’s ongoing rise, regular investors will also continue to acquire it. Due to this phenomenon, investors purchase ABC stock because of its strong performance, and short sellers buy ABC stock to get out of their position and reduce their losses.

In this instance, the outcome is a short squeeze or a sharp rise in the price of ABC stock that forces short sellers out of their positions.

Tips for trading short squeeze

One of the most effective short-term market drivers is short squeezes that can cause significant spikes in share price. Below are a few pointers for trading short squeeze.

• If you don’t pay attention, short squeezes, which can occur rapidly and move the price more drastically than a typical rise, can result in significant losses.

• When prices begin to fluctuate, additional buyers are informed, which amplifies the buying and may lead a stock to go parabolic.

• Always put hard brakes on your short positions, specifically if you are holding them overnight, to avoid getting trapped in a short squeeze.

• It’s also crucial to keep in mind that not all attempts to buy back shorted shares are fueled by good news.

• There may be a rush if the prime broker (the unit of a bank in charge of stock lending) demands the return of the borrowed shares.

• You should become familiar with the short interest ratio (SIR), which computes the amount of shares short divided by the stock’s average daily trading volume.

Risk involved in short squeezing

If the stock price rises further during a short squeeze, short sellers face the risk of suffering a substantial financial loss. Furthermore, a considerable short interest might go either way, which means that the stock price can still move up as well as down. Short interest is a sign that some investors anticipate a decrease in the stock price.

Bottom line

Short squeezes might offer both benefits and risks depending on your investor sentiment. Short squeezes can generate substantial profits for buyers. However, short sellers face significant risks and enormous losses if their forecast of a stock’s performance doesn’t pan out.

Disclaimer: Cryptocurrency is not a legal tender and is currently unregulated. Kindly ensure that you undertake sufficient risk assessment when trading cryptocurrencies as they are often subject to high price volatility. The information provided in this section doesn't represent any investment advice or WazirX's official position. WazirX reserves the right in its sole discretion to amend or change this blog post at any time and for any reasons without prior notice.