DEFINITION of ‘Crowded Short’
A trade on the short side with an overwhelmingly 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, currencies. A short squeeze on a crowded short can inflict tremendous damage, particularly if the participants were blissfully unaware that they were holding a short position, as sometimes happens in the currency markets.
INVESTOPEDIA EXPLAINS ‘Crowded Short’
Here’s one way to think of 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 for example. Now what if the rattlesnake suddenly comes to life. The resultant stampede to get out of the room (since most people are very unlikely to make an orderly exit in such a situation) is bound to hurt many people, since the aim is to get out at any cost and as quickly as possible.
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 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.
Crowded shorts can be identified by metrics such as short interest and the short interest ratio (SIR) for stocks. If these metrics are spiralling higher, 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 monumental 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.
On the subject of unwittingly holding a short position, be aware that a loan taken in a foreign currency amounts to a short position in it. This is because the foreign currency loan is generally converted to the local currency, but the eventual repayment has to be 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.
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.