DEFINITION of ‘Crowded Short’
A crowed short is a trade on the short side with a large number of participants, which greatly increases the risks of a short squeeze. A crowded short can occur in any asset class – stocks, bonds, commodities or currencies. A short squeeze on a crowded short can result in significant losses, particularly if the participants have not used a stop-loss order.
BREAKING DOWN ‘Crowded Short’
Consider this example to help understand the psychology behind a crowded short trade. Visualize a large number of people who are crowded into a small room to peer with morbid fascination at a comatose dangerous creature – like a rattlesnake or giant spider. Now, what if the rattlesnake or spider suddenly comes to life? The resultant stampede to get out of the room (since most people are doubtful to make an orderly exit in such a situation) is bound to hurt many people as the objective is to get out at any cost and as quickly as possible.
When do Crowded Shorts Occur?
Crowded shorts are typically in abundance at the tail end of a bear market. In equity markets, the start of a bull market is often marked by a massive covering of crowded short trades, leading to benchmark indices gapping up and posting significant advances, as occurred in March 2003 and again in March 2009 near the conclusion of the Great Recession. A crowed short can also come to an abrupt end due to company-specific news, such as a takeover or profit upgrade that causes a major short squeeze. For example, in 2015, coffee pod maker, Keurig Green Mountain Inc. surged roughly 70% on news of a takeover that caused a squeeze to suddenly end a long-term crowded short trade in the stock.
Monitoring Crowded Shorts
Investors can identify crowded shorts by analyzing metrics such as short interest and the short interest ratio (SIR) for stocks. If these metrics show rapid increases, it may signal that the short trade is getting crowded. The prospect of making some profits by following the (bearish) trend, in this case, should be weighed against the risk of incurring significant losses if the shorts get squeezed, as stocks can rise 10-fold or 20-fold in a matter of weeks or months once traders commence large-scale covering of short positions.
Crowded Shorts in the Currency Market
A loan taken in a foreign currency amounts to a short position in it. This is because the person or company typically converts the foreign currency loan into their local currency, but the eventual repayment gets made in the foreign currency. In 2015, tens of thousands of consumers in Eastern Europe faced sharply higher costs to repay mortgage loans denominated in Swiss francs, after Switzerland unexpectedly eliminated the cap on the franc’s exchange rate against the euro in January of that year. These consumers had borrowed in Swiss francs because interest rates were lower than rates on loans denominated in their local currencies. Unfortunately, the view held by most market participants that Switzerland would continue to cap the Swiss franc exchange rate had made the short Swiss franc trade an extremely crowded one. (For further reading, see: Why Switzerland Scrapped the Euro.)
Another example of a crowded short trade in the currency market is the massive carry trade that involved shorting the Japanese yen and going long on higher-yielding assets in the period from 2005 to 2008.