A forced liquidation, also known as a short squeeze, concerns both short and long positions. A forced liquidation of short positions affects short sellers, who are in effect forced to exit the market when prices rise rapidly. They will then try to close their short positions as quickly as possible in order to limit their losses.
A forced liquidation of long positions occurs when buyers – those who are long on a stock – are forced out of the market when prices suddenly fall. Again, they will try to close their positions quickly to avoid incurring significant losses.
Let’s find out more about short squeeze
What is a short squeeze?
A short squeeze or forced liquidation of short positions occurs when prices rise rapidly beyond the expectations of analysts and market participants. These forced sell-offs can have a big impact on investors positioned on the downside in borrowed stocks because they could spend more capital to buy back and return the stock, called a buyout to cover the overdraft, than expected.
They can also be detrimental to traders positioned on the downside through financial derivative products such as CFDs. Indeed, derivatives are traded with a leverage that can amplify your gains as your losses. This is especially the case during a forced liquidation of short positions or similar scenarios in which the markets act unexpectedly.
What are the factors behind a short squeeze?
A short squeeze is caused by a rapid and unexpected rise in the price of an asset, usually a stock. Short sellers will look to abandon their short positions as prices rise.
This causes the demand for stocks to increase, thereby reducing the supply. This change in dynamics between supply and demand generates an exponential increase, which worsens the effect of forced liquidation.
If investors use a buyback strategy to cover the overdraft with the borrowed stock, they will need to buy back the stocks they borrowed to open the short position before the maturity date. The due date in this context is the date on which the borrower agrees to return the action to the lender.
How to identify a forced liquidation of short positions?
To do this, many traders use chart indicators to find oversold stocks. If a stock or other asset is oversold, its price can be expected to rise. The relative strength index (RSI) and the Williams% R are popular indicators used to identify areas of oversold.
You can associate these indicators with the stock’s short ratio – the total number of stocks sold short but not yet hedged or closed, expressed as a percentage. This can help you confirm the indicator data: a lower short ratio indicates that fewer traders are heading lower in the stock now, which means they might expect the price to rise.
To find out the short ratio, divide the number of stocks sold short by the total available stocks, then multiply that result by 100.
Forced closeouts of short positions usually catch markets off guard, and indicators of oversold and a high or low short ratio are no guarantees that a sell-off will occur. Oftentimes, higher-than-expected company earnings, technological advancements, or new products revolutionizing an industry can cause prices to rise unexpectedly.
Example of short squeeze
A notable example occurred in October 2008, when the Volkswagen (VOWG) share price quintupled in two days, from $210 to $1,000. It totally took the market by surprise and for a short time, Volkswagen was the most profitable company in the world.
The short squeeze was caused by a perfect combination. Porsche announced that it had gained 74% of control of Volkswagen’s voting shares, which caused its share price to rise sharply, with short sellers being forced to pay $1,005 per share to close their positions.
Another more recent example would be the Tesla Stock Price (TSLA) in early 2020. Tesla stocks were previously the top short selling stocks on the NASDAQ, but a string of good news, including better fourth quarter results. expectations, caused the stock price to rise to $900.
Short sellers were caught off guard and, like Volkswagen, rushed to buy and hedge their short positions and limit their losses. Prices have risen even more, resulting in exponentially larger losses for short sellers.
How to negotiate a short squeeze?
- Open or log in to your trading account
- Find the value that interests you
- Perform your own analysis
- Put in place risk management tools
- Open, monitor and close your position
To trade after a short squeeze, you should open a position that will benefit from a rise in prices. This means that you would open a long (long) position with CFDs after identifying a forced liquidation of the short positions.
CFDs use leverage, which means you don’t have to own the shares and can open a position with a low deposit, called a margin or hedge.
If you already have a Securities Account, you can buy the shares and become the owner. You will then become a shareholder of the company with voting rights and be eligible to receive payment of dividends, if applicable.
An investment position will be profitable if the value of the shares increases, which means that they will generally perform well during a short squeeze phase which leads to rapid rise in prices.
Short Squeeze: Key things to remember
- Forced close outs of short positions are often bad news for investors using short selling with borrowed stocks.
- They occur when prices rise rapidly and unexpectedly.
- This can catch short sellers off guard and force them to buy back the borrowed stocks at a much higher price to close their positions..
- As a result, demand for equities increases and supply decreases, pushing prices even higher.
- Losses for short sellers can be exponential in the event of a short squeeze, and the gains for long positions can be substantial.