Short squeezes are a well-known occurrence in finance, but they have also become a notable phenomenon in the cryptocurrency market, where price volatility is already high. A short squeeze happens when market conditions defy predictions, causing a rapid increase in buying pressure that drives the asset’s price higher. Recognizing a short squeeze is crucial for cryptocurrency traders, as it can lead to sharp price surges and significant impacts on their portfolios. This article explores the concept of a short squeeze in the crypto market, offering insights into its causes, how to identify it, and strategies for navigating such situations effectively.

Understanding Short Squeeze

A short squeeze begins with short selling, where traders borrow and sell cryptocurrency at the current market price, expecting to buy it back later at a lower price and profit from the difference. These traders, known as short sellers, rely on the asset’s value dropping.

However, the price sometimes rises sharply instead of declining due to factors like positive news or shifts in market sentiment. As a result, short sellers are forced to buy back the cryptocurrency at higher prices to limit their losses. This wave of buybacks further drives up the asset’s price, triggering a short squeeze.

How Does Short Squeeze Occur?

Source: B2Broke

Several factors can trigger a short squeeze in the cryptocurrency market. These include:

Short Selling

Traders anticipating a decline in a cryptocurrency’s value engage in short selling. This involves borrowing the cryptocurrency and selling it at the current market price to repurchase it later at a lower price. The difference between the selling and buying prices is taken as profit.

Traders can short cryptocurrencies on decentralized exchanges (DEXs) and centralized exchanges (CEXs) that offer margin trading. Platforms like Gate.io are examples of exchanges where cryptocurrency shorting is possible.

Rising Cryptocurrency Value

When short selling is followed by an abrupt hike in the value of the cryptocurrency, short sellers face a built-up trade loss portfolio. Built-up trade loss is the accumulated financial loss from trading in the cryptocurrency market over a specific period.

Buybacks

Due to the cryptocurrency’s rising value, short sellers are forced to repurchase it at a higher price to minimize further losses. This buying activity contributes to an additional increase in the cryptocurrency’s price.

Positive Sentiments

The rising price helps the asset gain investor’s confidence, and traders tend to pump more funds into it, leading to an intensified short squeeze.

Causes of Short Squeeze

Positive News

Source: [Exolo ]

Unexpected positive news, such as system upgrades, regulatory approvals, or strategic partnerships involving a heavily shorted cryptocurrency, can shift market trends. This often prompts traders to buy more of the asset, driving its value up sharply.

Limited Float

A limited supply for trading can cause significant price impacts with a minor and consistent increase in demand for the asset. This causes a value surge effect, leading to a short squeeze.

Low Liquidity

Source: [Exolo]

Cryptocurrencies with low trading volumes are more prone to short squeezes due to their lack of market depth, which affects the ability of short sellers to exit positions smoothly.

Shift in Market Sentiment

Source: [Exolo ]

A projected bullish run in the future attracts attention to a cryptocurrency, subsequently leading to price increases, which in turn lead to a short squeeze.

High Short Interest

Source: [Exolo ]
A high volume of short positions on a cryptocurrency indicates significant short interest, suggesting that many traders anticipate a decline in its price.

Technical Indicators

Source: [Exolo ]

When the value of a cryptocurrency or decentralized digital asset passes a certain threshold caused by technical triggers, traders tend to buy the asset in anticipation of a sustained bull run, thus causing a short squeeze.

Detecting Short Squeeze

Various technical indicators can identify a short squeeze in the cryptocurrency market. The following indicators provide traders and investors with signals that a short squeeze may be occurring:

Squeeze Momentum Indicator

Source: [Exolo]
This indicator by LazyBear, available on TradingView, combines Bollinger Bands and Keltner Channel to spot short squeezes. Positive values in the chart indicate upward momentum, a bullish market trend.

Relative Strength Index (RSI)

Source: [Exolo]

RSI is a momentum oscillator that gauges crypto value speed and changes to evaluate overbought and oversold conditions. An RSI index above 70 could indicate a short squeeze condition.

Volume Indicator

Source: [Exolo ]

A sudden increase in a cryptocurrency’s trading volume could signal a short squeeze. A high trading volume with a corresponding increase in the value of a particular cryptocurrency also indicates that short sellers are covering their positions.

Effects of Short Squeeze

The impact of a short squeeze on cryptocurrency can be classified into two broad categories:

Positive Effects

Some of the positive effects of short squeeze are:

Value Appreciation

A short squeeze leads to a rapid increase in the value of cryptocurrencies and digital assets. This benefits holders of the assets who bought them during the early stages of the short squeeze.

Positive Sentiments

The sudden rise in value could possibly boost traders’ confidence in cryptocurrency and other digital assets, leading to prolonged bullish trends.

Enhanced Market Liquidity

An increase in buying activities caused by a short squeeze leads to an increase in the trading volume of cryptocurrency and digital assets under a short squeeze. This allows for larger trades without having much effect on the market.

Negative Effects

Some of the negative effects of short squeezes include:

Increased Volatility

Since a short squeeze is often an unexpected shock, traders do not know when it will start and its duration. Hence, it is often difficult for traders to predict the market and efficiently manage their positions.

Irrational Decision-Making

The Fear-of-Missing-Out (FOMO) syndrome might cloud traders’ decisions by overvaluing cryptocurrency and digital assets. This leads to massive losses for traders when the value of the asset suddenly crashes.

Strain on DEXs and CEXs Platforms

Short squeezes might unexpectedly strain the technological infrastructure of both decentralized and centralized exchange platforms. This leads to technical issues in their systems, interruptions, and downtime in their trading services.

Case Studies of Short Squeeze

The cryptocurrency market has experienced several notable short-squeeze events. Here are some of the most significant ones:

BTC Short Squeeze

Source: Bitcoin.com News

Bitcoin’s value experienced a significant surge, exceeding $40,000 within a short period following a prolonged bearish trend. This surge propelled the total cryptocurrency market capitalization above $1 trillion for the first time. The increased retail adoption of Bitcoin for everyday transactions was a primary catalyst for this price appreciation. As a result of the upward price movement, traders were compelled to purchase bitcoin at higher prices, triggering a short-squeeze rally.

ETH Short Squeeze

Source: Statista

In 2021, ETH experienced a rapid price increase after consolidation, increasing in value from around $400 in 2020 to around $3,000 in 2021. This sudden change caused short positions to close, pushing the value upward, leading to a short squeeze.

DOGE Short Squeeze

Source: Forbes

Driven by social media hype and retail investors, the value of DOGE rose from about $0.0003 to around $0.8 in 2021. The hype led to a short squeeze as traders who shorted their DOGE had to cover their positions.

Trade Strategies for Short Squeeze

Since the cryptocurrency market is highly volatile and its values are very unstable, traders must know how to deal with a value-sensitive situation, such as a short squeeze, to minimize losses. The following are ways to deal with a short-squeeze situation in the market effectively:

Sequential profit-Taking

To protect one’s holding during short squeeze periods, it is important to sell a fraction of one’s stakes in phases and keep the remaining open to accumulate further gains. Thus, in the event of a market crash, the trader would suffer little to no loss.

Quick Entry and Exit

It is important that traders set clear entry and exit points to capture gains and avoid losses. To avoid losses, stop-loss orders can also be implemented at a reasonable threshold, irrespective of the market condition.

Trade Responsibly

Traders are encouraged to only trade with money they can afford to lose in the event of an extreme market crash and to prepare for market profits and losses.

Monitor Volume and Indicators

Traders should watch for shifts in trading volume and technical trends, such as RSI and Moving Averages, to successfully predict short squeeze durations.

Conclusion

A short squeeze in the cryptocurrency market presents opportunities and risks for traders due to its unpredictable nature and potential for rapid price surges. Understanding the factors that trigger a short squeeze, such as positive news or shifts in market sentiment, is essential for recognizing and navigating these events. By leveraging technical indicators, monitoring market volumes, and implementing responsible trading strategies, traders can mitigate potential losses and capitalize on short-squeeze situations. However, caution is crucial, as the volatility of short squeezes can lead to irrational decisions and increased market risk.