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Everything You Need to Know About Crypto Short Squeezes

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2022-11-08
Everything You Need to Know About Crypto Short Squeezes

Most traders and investors rely on bull markets to earn profits, traditionally buying low and selling high, but seasoned traders will also look to earn money during bear markets. To do so, they’ll do something called short-selling, which generates profits even when a cryptocurrency’s price goes downwards. However, as we’ve seen in the case of GameStop’s stock price earlier last year, when an asset gets shorted too heavily, a phenomenon called a short squeeze can occur, leading to a sharp increase in price and causing heavy losses for those holding short positions. To better understand when and how this happens, this article will explore the idea of short-selling, the cause of short squeezes, and an overview of what occurred during the GameStop episode.

The Concept of Short-Selling

To understand the phenomenon of short squeezes, it’s necessary to first discuss the idea of short-selling a cryptocurrency. The act of short-selling – also commonly referred to simply as “shorting” – takes an opposite position of those buying and holding cryptocurrencies and waiting for its price to rise. In bear markets, prices go downwards, and short-sellers take advantage of this to profit by first borrowing a sum of cryptocurrencies and immediately selling them at their current price. Because shorting positions predict that prices will continue to fall, short-sellers will then wait until prices are lower to buy back the sum they owe the lender and return it.

Calculating the profit is simple: take the initial selling price (at a higher price point) and then subtract from it the subsequent buying-back price (at a lower price point). For example, a trader can borrow one Bitcoin (BTC) at US$50,000 and sell it immediately. BTC subsequently drops to US$30,000, and the trader decides to buy one back to return to the lender. His profit will then be US$20,000 minus any transaction/exchange fees.

While shorting is a good way to earn profits even in a bear market, naturally, there are also various risks involved. Mathematically, unlike long positions, where losses are capped, and earnings can be infinite, short positions have these traits reversed. Because you’re predicting the price to fall, the most it can drop to is US$0, meaning your potential profits are capped at 100%. On the other hand, because the maximum price of a cryptocurrency is infinite, your exposure to losses is, therefore, also infinite.

If you’re margin trading, your risk exposure will also increase significantly. Not only will you have to cover potentially unlimited losses, but you’ll also be responsible for any margin calls while your positions are open. If you’re unable to meet margin calls or your losses exceed 100%, exchanges would likely liquidate your account automatically.

Snowballing Into a Short Squeeze

So what exactly is a short squeeze, and when does it occur? A short squeeze essentially describes the unusual circumstance of an unexpected rise in the price of a cryptocurrency (or stock) that is heavily shorted. The reason behind the rise can be anything ranging from new updates to a blockchain to even just pure market speculation.

Regardless, when prices begin to rise, investors holding short positions will begin suffering losses as their buy-back price is now higher than their initial selling price. In order to minimize these losses, many short-sellers will buy back the amount they owe as quickly as possible. The increase in demand for the cryptocurrency naturally drives up its price, even more, leading to more panic among those shorting the coin and forcing them to buy their sum back as well. As you can see, the effect starts to snowball, and the price continues to rocket upwards due to the sudden influx of demand.

To exacerbate the situation, sharp price increases over a short period of time attracts other buyers as well who hope to go long and make a profit. The entry of these participants further elevates the price of the cryptocurrency in question, leading to significant losses for those who held short positions, especially if they have been slow to respond.

Making a Profit Off of a Short Squeeze

Just as we mentioned above, it is possible to make a profit off of a short squeeze by betting against it. If you’re confident that a price increase is coming for a token that is being heavily shorted, there is a chance that a short squeeze could occur, sending prices to skyrocket and consequently turning your long positions highly profitable. In fact, this is exactly what happened with the incredible case of GameStop stocks at the beginning of 2021.

In the months leading up to 2021, the video game retailer had been struggling financially due to increased popularity in digital game sales as well as reduced foot traffic in brick-and-mortar stores. The financial turmoil it faced translated into an attractive target for short-sellers who believed that GameStop’s (GME) stock price would plummet as its business fought to stay alive.

In a turn of events, however, news broke in January that GameStop could claw its way back into the business and return to profit over the span of just a few years, and noticing that GME was heavily shorted, retail investors began opening long positions. The trend began going viral thanks to forums such as Reddit, where users from r/WallStreetBets began rallying to buy GME stocks and push its price upwards.

The movement gained momentum as short-sellers started to cover their losses, further increasing GME prices and leading to institutional investors joining in on the ride. Large market participants such as Chewy co-founder Ryan Cohen and Scion Asset Management’s Michael Burry opened long positions, and soon other celebrities and influential figures chimed in, including Tesla, SpaceX, Boring Company, and now Twitter CEO Elon Musk as well as renowned venture capitalist Chamath Palihapitiya.

Ultimately, the resulting short squeeze led to billions of dollars in losses suffered by major hedge funds that held massive short positions, and those who went long earned a significant amount in return. In the span of a month, GME’s price went from just below US$5 to a staggering US$325. At its peak, it reached an all-time high of US$347.51.

Learning From GME

As the GME episode has illustrated, it is possible to make a profit by betting against a heavily shorted stock or cryptocurrency, but with any type of trading, there will always be inherent risks involved. A cryptocurrency may attract a high amount of short-sellers because the general sentiment is that it would drop in value, and those hoping to run contrary to market trends should research their strategies carefully and responsibly. Those looking to profit off of short positions during a bear market should also pay attention to any warning signals there may be in case of an impending short squeeze.

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Disclaimer: This article is for educational purposes only and is not intended as investment advice. Qualified professionals should be consulted prior to making financial decisions.