The short squeeze strategy is built on the notion of “Short Selling.” It’s a sophisticated trading technique. When traders believe the price of a stock will decline, they engage in short selling. As a result, they borrow shares and sell them at market value. If the share price falls, the creditor will purchase the shares and sell them to the lender.
Short selling has two components: selling to open and buying to close. Your short position begins when you sell the stock and ends when you buy it back. Another way to think of it is as the opposite of a conventional investment: you sell the security first, then expect to buy it back at a lower price.
Short selling helps traders to benefit from a decrease in the price of an asset. It’s a popular way to mitigate downside risk, hedge current positions, or simply express a bearish market stance.
Shorting, on the other hand, can be a high-risk trading strategy at times. As there is no upper limit to the price of the asset.
Now that we know the meaning of Short Selling. Let’s understand the concept of “Short Squeeze.”
What is Short Squeeze Strategy?
A short squeeze is coming from a crowded, short trade. This means that there are a massive number of short-sellers on a certain stock. And that means there’s a lot of risks involved.
Short sellers are placing bets that the price of the asset will drop. Conversely, if the price rises, short positions begin to amass an unrealized loss. As the price rises, short-sellers may be forced to close their positions. This can occur through stop-loss triggers, margin liquidations, and futures contracts. It can also happen simply because traders manually close their positions to avoid even greater losses.
But, how are short-sellers closing their positions? They’re buying. That’s why a short squeeze leads to a sharp price spike. As short sellers close their positions, the cascading effect of buying orders adds more fuel to the fire. As such, a short squeeze is usually accompanied by an equivalent peak in the volume of trading.
Short interest is among the factors that lead to a short squeeze. The number of shares sold is short but not yet covered or closed. Short interest is often expressed in terms of the flotation of the stock. The float of the stock is the number of shares available for trading. However, if 100 million shares are floating and 50 million shares are sold short, the short interest rate is 50 percent.
Short interest on the stock is usually updated at the end of each month. Even though “normal” short interest may differ by company and even industry, double-digit numbers generally mean that investors are pessimistic. These companies are ideal targets for short-squeeze.
Here are other things to know about. The greater the short interest, the easier it is to bait short-sellers and compel them to close their positions. In other words, the more the liquidity there is to bait, the higher the volatility increase may be due to a short-term tightening. In this sense, short-term tightening is a temporary increase in demand and a decrease in supply.
Well, let’s understand how short-squeeze is executed with a real-life example.
Real-Life Example of Short Squeeze,
GameStop is one company that has raised awareness about short squeezes. Following the most recent short squeeze, average investors are taking a closer look at this sometimes profitable strategy. So, what transpired with GameStop’s stock?
Robinhood is a relatively new trading platform. It allows average folks to invest in the stock market. Reddit, on the other hand, is a social media platform for people who share common interests. Investing is one of them. Hedge funds were shorting GameStop stock, according to retail investors who gathered on Reddit. As a result, the public banded together and began buying as many shares as they could, whether through Robinhood or their portfolio manager. As a result of the increased demand, the price increased. As a result, short sellers scrambled to buy back GameStop stock, driving up the price even higher.
Looking at the above example one can understand the risk involved in using this strategy. Before you enter a short position, make sure you understand the consequences of a short squeeze. Otherwise, you could perhaps end up with higher losses.
Disclaimer: There are potential risks relating to trading and investing and you should not trade with money that you cannot afford to lose however, for those that educate themselves and adopt appropriate risk management strategies, the potential update can be significant. Please note that all opinions, research, analysis, and other information are provided as general market commentary and not as specific investment advice.
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