Short squeeze: the carry trade’s curse

Sure, there’s a ton of liquidity in the forex trading market, with billions and trillions of dollars in various currencies changing hands each day.

What happens when it all moves in the same direction?

This has been known to occur. The majority of forex traders decide (for example) that a particular currency pair is going down. Perhaps there’s a strong interest rate differential between the two nations’ central banks, which is expected to widen even further in the months ahead. Perhaps one nation is booming economically and the other suffers from a protracted recession which is expected to worsen. Whatever the reason, Currency A is weakening and Currency B is strengthening, leading to a long-term downtrend that seems to have no end in sight.

(This situation can of course also develop the other way around, leading to a long-term uptrend. For the sake of simplicity, this article will concentrate on the former set of circumstances.)

Below is a great example. This is the daily chart for the Euro versus the Australian dollar, currency pair EUR/AUD:

In March 2009, with the first round of the global financial crisis easing, the RBA’s cash rate stood at 3.25% (later lowered to 3.00%) and the ECB’s stood at 1.50% (later lowered to 1.00%). As forex traders regained their courage and re-entered the carry trade, this was one of the first currency pairs to reflect that dynamic, with a sustained downtrend that lowered the exchange rate from about 2.00 to touch 1.3926.

Then, on 19 May 2010, something odd happened:

A German ban on short-selling certain financial instruments triggered a wave of risk aversion in jittery financial markets, setting off a round of short covering and position exiting in this formerly one-way trade. Remember that, to cover a short, the short-sellers must buy the currency they sold, and that buying a currency drives the price higher.

The result was a suddenly rising price, which triggered other short-sellers’ stop losses, which initiated a new round of buying to cover those shorts, which forced the price even higher, which triggered even more stops, and so on.

This vicious cycle is called a short squeeze (a long squeeze if a collapse happens in a rising currency pair) and it tends to occur in thin markets with illiquid currencies, such as those frequented by carry traders. The sudden flood of reversing short positions drives the price substantially higher in an amazingly brief period of time. Forex traders short the pair, faced with this astonishing rally, understandably tend to panic and exit their open positions as fast as possible, sending the price even higher as their profits melt away into frighteningly mounting losses.

On 19 May, EUR/AUD opened at 1.4112. On 20 May, it closed at 1.5276.

Forex traders shorting (or buying) the least liquid crosses in this market are warned to keep their stops tight and preferably trailing. Better to be stopped out of a good trade by an anomalous spike that to be on the wrong side of a widening short squeeze.