Short selling occurs when the price of an asset increases sharply because many short sellers are forced out of their positions.
Short sellers are betting that the price of an asset will fall. If the price rises instead, short positions begin to accumulate unrealized losses. As the price rises, short sellers may be forced to close their positions. This can happen through stop-loss orders, liquidations (for margin and futures contracts). It can also happen simply because traders manually close their positions to avoid even greater losses.
So, how does a short seller close his position?
They buy. This is why a short squeeze leads to a spike in price. As short sellers close their positions, a ripple effect of buy orders adds fuel to the fire. Therefore, a short squeeze is often accompanied by an equivalent spike in volume.
Hereâs another thing to consider. The greater the short interest, the easier it is to trap short sellers and force them to close their positions. In other words, the more liquidity there is to trap, the more volatility there can be due to short selling. In this sense, short selling is a temporary increase in demand while supply decreases.
The opposite of a short squeeze is a long squeeze â although less common. A long squeeze is a similar effect that occurs when longs are trapped by continuous selling pressure, leading to a sudden spike in price.
