How to Avoid a Short Squeeze in Forex and Stocks

Apr 21, 2021 07:41 PM ET
How to Avoid a Short Squeeze in Forex and Stocks

A short squeeze refers to a situation where a highly shorted stock rises parabolically, leading to substantial losses by the short-sellers. It is one of the most feared scenarios among the short-only and long-short money managers. In this article, we will look at what a short squeeze is, how it works, and how you can avoid it.

What is short selling?

To understand what a short squeeze is, it is important to know what short selling is. Shorting a financial asset is the process where you bet against an asset and hope that its price will fall. For example, if a company’s stock is trading at $20 and you believe that it will fall to $10, you can short it. To do that, you just need to select the sell option offered by your broker.

Technically, shorting a stock is a relatively complicated process. You need to go to a broker, borrow some shares, sell them, wait for the stock to drop, buy the shares back, and return them to the broker. If you have $10,000, you can borrow 500 shares of the company mentioned above. When the stock drops to $10, you buy 500 shares at $5,000. In this case, your profit will be $5,000.

Shorting is usually a riskier process than being long. That’s because, when you buy a stock, the maximum loss you can make is losing all your money if it drops to $0. When you short a stock, you can make an infinite loss because the stock does not have an upper limit. In the past, we have seen stocks rise from less than $10 to more than $1,000.

Therefore, a short squeeze happens when the price of a stock, currency, cryptocurrency, or any other asset that one is short experiences a parabolic move.

Examples of famous short squeezes

There have been many short squeezes historically. The most recent is what happened in the first quarter of 2020. In the so-called Wall Street Bets, social media users managed to push shares of unloved companies like GameStop and AMC sharply higher.

For example, GameStop stock jumped from less than $20 to almost $500 within a few days. In this case, while the bullish investors made a substantial return, short sellers lost billions of dollars.

GameStop short squeeze

GameStop short squeeze

Another good example is Tesla. The company has been controversial for years. This led many investors like Jim Chanos to short the stock. Some even increased their short bets at the onset of the coronavirus pandemic. Their argument was that the company’s valuation was overstretched and that there was competition. However, in the past few years, Tesla shares have jumped from less than $100 to more than $700. That has seen many short sellers lose billions of dollars.

Tesla short squeeze

Tesla short squeeze

Causes of a short squeeze

There are several causes of short squeezes in forex and stocks. First, it could happen because of the so-called pump and dump schemes. This is a situation where a person or group of persons promote a stock or currency, push it higher, and then exit. This is what happened during the Wall Street Bets mania in 2021. The schemes are especially popular among penny stocks that are thinly traded.

Second, a short squeeze could happen because of a merger and acquisition situation. When a company announces an acquisition, it has to pay a premium. Therefore, shares of the company being acquired tend to jump in a bid to realize this value. This sharp rally usually hurts investors who are short the company.

Third, actions by the Federal Reserve could lead to a short squeeze. The rally in stocks in 2020 that pushed companies like Tesla higher was partly because of the Federal Reserve, which brought interest rates low and launched a major quantitative easing drive.

How to avoid a short squeeze

There are several strategies to avoid a short squeeze in the market. Some of the most popular ones are.

Having a stop-loss or a trailing stop-loss

The simplest way of avoiding a short squeeze in stocks and forex is to have a stop loss. This is a tool that automatically stops a trade when a certain level is reached. For example, if you shorted the stock at $10, you can have a stop loss at $13. In this case, the trade will automatically end when it reaches $13 and save you money if it continues to surge. 

A trailing stop-loss is similar to a normal stop-loss. The only difference is that it captures your profits in case of a major pullback. In the example above, if the stock falls to $8 and then suddenly jumps to $13, your original profit will be captured.

Size of your short trades

Another way of avoiding a short squeeze is only allocating a small portion of your funds to short trades. If you have a portfolio of $10,000, you should allocate less than 5% of it to short trades. This will help to limit the number of losses that you can make in case of a short squeeze.

Avoid short-only strategy

Short-only is a strategy where a trader focuses on shorting financial assets. While some traders have succeeded in it, the strategy is relatively riskier because of the overall risks of shorting that we have mentioned above. Instead, if you are interested in shorting, we recommend that you only do so partially. In this case, most of your portfolio should be dedicated to long trades.

Other popular ways of avoiding a short squeeze are avoiding overnight trades and avoiding making overleveraged trades. Also, you can use arbitrage, where you hedge your short trades by using options or buying similar assets.

Final thoughts

A short squeeze can be a scary thing because it can make you lose more money than what you shorted. Indeed, we have heard stories of people who have either suffered catastrophic margin calls or those who have been forced to take loans to pay back these trades. In this article, we have looked at what a short squeeze is, why it happens, and how you can avoid being caught in it.

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