What Is A Short Squeeze In Cryptocurrency?

The cryptocurrency industry, and by extension, all financial markets, have a lot of jargon. For newcomers, some of these terms may seem overwhelming, yet they are essential knowledge. For example, a short squeeze is a direct result of many traders shorting an asset or market at the same time.

Going short against a market or asset can be beneficial, primarily under bearish conditions. Even though it may not always seem like it, bear markets can create money-making opportunities for those brave enough to follow the trend. Short selling becomes a desirable option under those circumstances. One benefit of short selling is creating a short squeeze, which is a sudden price increase that “traps” short-sellers.

As the name suggests, a short squeeze is often short-lived, and the downtrend will resume shortly after. However, it is one of the more intriguing market phenomena one can witness. It is also worth noting that opening a long position at the right time allows traders to profit off such short squeezes.

The Concept Of A Short Squeeze

The short squeeze can occur in any financial market after the asset’s price sharply increases. Such a development will force short-sellers to leave their positions or risk destroying their portfolio. Short squeezes are relatively common, although they may prove a bit tricky to predict.

For short-sellers, the objective is simple” follow a bearish price trend and hope it will keep declining. They can employ multiple tools and methods to determine the feasibility of that approach, including technical analysis. However, if prices were to go up, their short positions will create an unrealized loss. If this loss becomes too high, short-sellers are better off closing their positions through stop-loss triggers or liquidations for margin and futures trading. Closing a position manually is also available, although it never hurts to build in some extra safety. 

When numerous short positions close in a short timespan, the asset’s price is likely to keep increasing sharply. Thus, a price spike will occur, which represents the short squeeze. When shorters close positions, more and more buy orders will come in to acquire the asset. It is prevalent to see a short squeeze coincide with a significant increase in [temporary] trading volume. 

One factor to consider is the short interest in play at any given time. As this interest amount grows, it will become easier to “trap” short-sellers and force positions to be closed. If there is more liquidity to be trapped, the volatility will increase exponentially. There will always be a time when demand increases and supply decreases, creating a short squeeze. 

As is often the case, there is an opposite of the short squeeze concept. Referred to as the long squeeze, it occurs when there is cascading selling pressure trapping long positions, resulting in a quick price collapse. Long squeezes are far less common, however, yet it remains essential to acknowledge their existence.

How To Make It Happen

All of the above sounds great in theory, but triggering short squeezes is often a bit more complex. While we know there needs to be a sudden increase in buying pressure, it will not materialize automatically. Short-sellers realize they are walking a very tight rope by going against market trends, even though there is good money to be made. However, when the sentiment goes against the short-sellers, they often scramble to cover losses through buy orders. As more traders do the same, the price for the asset will go up rapidly.

No market is immune to short squeezes, at least in theory. If there is an opportunity to short a particular market, a sudden and brief squeeze is always on the horizon. However, any market that has little or no shorting options can still suffer from massive price bubbles. Therefore, it is healthy for traders to bet against markets and assets, as no market can keep going up in value indefinitely.

One signal to look out for is the ratio between short and long positions. If the short positions vastly outweigh the long positions – or vice versa – a squeeze is likely to mature. Keeping an eye on the long-short ratio can prove beneficial to all traders regardless of their market experience. It is a very intriguing metric that will often help gauge how market sentiment evolves.

Examples Of A Short Squeeze

While most people would automatically look at the cryptocurrency industry for short squeezes, more examples exist in the stock market. Whenever a company has low sentiment despite maintaining a high price, the number of short positions will increase. Should positive news or an announcement occur, all short positions are at risk of liquidation. The result: massive buying, increasing the stock price, and a short squeeze.

Some stocks tend to attract more shorters than others. Tesla (TSLA) , and more recently, Gamestop (GME), are two such stocks that seem to be subject to a lot of envy. It is one of, if not the most shorted stock in history. Their prices have seen very high peaks and steeper lows, resulting in multiple potential short squeezes. 

Back to cryptocurrency markets, it is evident there are numerous options to short markets. As soon as prices for Bitcoin or Ethereum go up, there will be those hoping for a sharp dip. Additionally, the use of derivatives and high leverage makes it more appealing to short Bitcoin. However, there is always a chance of trapping short-sellers, even with minor price movements. Frequent short and long squeezes occur in this industry. Overleveraging can be a death sentence for one’s portfolio.

With a volatile asset like Bitcoin, bearish market trends are very challenging. When the market goes down for a few days, people have high expectations of this trend continuing. Moreover, it creates low market sentiment, fueling the idea of shorting the leading crypto asset. In some cases, a short squeeze will occur, and the price makes a quick reversal. 

How To Identify Short Squeezes?

That is perhaps the million-dollar question for a lot of traders. While we know what to look for to figure out when it can occur, there is never a guarantee of a squeeze taking place. Prices drifting lower and low market sentiment are a common occurrence in the cryptocurrency industry, unfortunately. As such, it is safe to say a short squeeze is a technical pattern rather than an actual event”. 

Traders looking to take advantage of a short squeeze may want to reconsider. A sudden price burst is usually short-lived and may not signal a market reversal. It is possible a major short liquidation occurs, catapulting the price up by 10% or more. However, there is very little time to take advantage of such a development, and it remains risky to do so. 

Closing Thoughts

On paper, a short squeeze is a very intriguing phenomenon that can make many traders unhappy. People who purposefully short the market are always at risk of having the momentum turn against them. Although no asset can keep appreciating without a correction, specific markets tend to behave differently from the norm. Cryptocurrencies, such as Bitcoin, are a prime example of somewhat unpredictable markets.

When a short squeeze occurs, those with short positions will get trapped. Their only recourse is covering their open positions, which means placing buy orders. When the price spikes suddenly, it remains unclear if that trend remains in place. However, if short-sellers do not cover their positions, the situation will escalate and snowball very quickly.

Facing a short squeeze is a big problem for those who are [relatively] new to leveraged trading and shorting. It may seem appealing to go for the big bucks right away, yet all financial markets can turn around on a dime. The potential losses while shorting are more significant than the potential profit one can secure. 

That doesn’t mean it can’t be worthwhile to short specific markets when the time is ripe. No asset can keep going up in value without a setback sooner or later. When that time has come, opening a [temporary] short position can prove beneficial for those who want to make a quick buck. 

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