Short squeezes can result in staggering losses. Use these two short selling tactics to avoid massive losses (both are pulled from the options trader’s playbook).
When we’re stuck in a bearish trend (or bear market), some traders short the markets in the belief they will continue to go down. Markets historically go up, so this is a risky move, even with technical indicators on your side.
I like to place contrarian trades, so this has been on my mind recently. Last week, markets didn’t just move up – they gapped higher. Those who were caught short were forced to act quickly.
Now, the best traders tend to be very flexible. They will accept being wrong, cut their losses, and start looking for new trade ideas. If you can do this when shorting the markets, you’ll be OK.
When it comes to short selling, think like an options trader
Options traders have a leg up here. We know that changing tactics can be the difference between taking a small loss and a larger, more devastating loss. Our trades have a more condensed timeline than a long-term investment. We have to be ready to act fast.
And this brings me to short squeezes, which occurs when a trader holding a substantial short position (aka, is looking for the markets to go down) is suddenly hit with a potential loss as the market moves higher. Even worse, if the market gaps up and holds steady, those losses can become quite large. This scenario is exactly what played out last week.
When we place a trade, whether bullish or bearish, we do so because we believe our analysis is right. Technicals, fundamentals, sentiment, and the current trading environment are in alignment. But if our timing is off, then our positioning could have devastating consequences. Such is the case when the markets start squeezing the short sellers.
Short sellers must think like options traders – do not overstay your welcome. Markets move down like a brick thrown out of a window, and they move up like an escalator. Place a short-term trade, and get out quickly!
Furthermore, if the buyers sitting on the sidelines sense weakness by the short sellers, a massive buy signal might start flashing. Short sellers are then forced to cover (or buy) their mistakes. This doesn’t happen often, but a short squeeze can be very powerful and distribute plenty of pain.
Always place a trade knowing you can be wrong. Be flexible, and you can keep short losses to a minimum. Be stubborn, and well … you’re not going to enjoy the outcome.
