What Is a Short Squeeze?
A short squeeze is a rapid surge in the price of an asset, typically triggered by a large number of short-sellers being forced to cover their positions simultaneously. When the asset price rises unexpectedly, short-sellers buy back the asset to limit their potential losses, further driving up the price.
In the cryptocurrency market, short squeezes can be particularly dramatic due to the high volatility and leverage often involved in trading. When a heavily shorted cryptocurrency experiences a sudden price increase, it can create a cascading effect as short-sellers rush to exit their positions, leading to a rapid and amplified price surge.
What Causes a Short Squeeze?
Traders employ short selling for various reasons, including hedging against potential losses in a particular industry, capitalizing on perceived overvaluations, or exploiting price discrepancies through arbitrage strategies.
A short squeeze typically occurs when the price of an asset starts to rise unexpectedly, contrary to the expectations of short-sellers. Factors such as positive news about the asset, a sudden surge in buying pressure, or a technical breakout, can drive this price increase.
Tokens with high short interest, low liquidity, or a concentrated ownership structure are generally more susceptible to short squeezes, amplifying price movements and making it more challenging for short-sellers to exit their positions without significantly impacting the market.
Examples of such coins range from meme coins like Shiba Inu (SHIB) and newly launched tokens to DeFi tokens with low market capitalization.
How Does a Short Squeeze Work?
A short squeeze unfolds through a series of interconnected events, typically involving the following key elements:
Borrowing on Margin: Short-sellers initially borrow the asset they intend to short, often using margin, amplifying both potential profits and losses.
High "Short Interest": A high short interest indicates a large number of shares are sold short, creating a potential vulnerability to a squeeze.
High "Days to Cover": Indicates the number of days it would take for short-sellers to cover their positions. A high "days to cover" suggests an increased susceptibility to a short squeeze.
Trigger Event: A catalyst, such as positive news, unexpected buying pressure, or a technical breakout, triggers an initial price increase. For example, Ethereum's recent underperformance relative to Bitcoin could lead to a short squeeze if positive news or developments trigger a sudden surge in buying activity, forcing short-sellers to cover their positions.
Self-Perpetuating Cycle: As the price rises, short-sellers are forced to buy back the asset to limit losses, further driving up the price and creating a self-reinforcing cycle.
What makes a short squeeze particularly potent in the cryptocurrency market is the combination of high liquidity and rapidly shifting market sentiment. Sentiment-driven markets are more prone to sudden price swings, which can quickly trigger a short squeeze. Short-sellers rush to cover their positions, leading to forced buying that amplifies the price movement.
Effects of a Short Squeeze
Repeated short squeezes can significantly alter market sentiment and perception. If a token becomes known for frequent short squeezes, it can cement its reputation as a volatile asset, potentially deterring institutional investors who seek more stable investments.
However, the increased volatility may also attract short-term traders and speculators seeking to capitalize on the price swings. The fear of missing out (FOMO) or the panic of incurring significant losses can lead to emotional decision-making, which can be detrimental to trading performance.
For long-term holders, a short squeeze can reinforce their conviction and encourage a "HODLing" mentality, as they see the token's value appreciate rapidly.
Short Squeeze vs. Short Covering
Short covering refers to the act of short-sellers buying back an asset to close their positions. It is a routine practice in trading and typically has a minimal impact on the market price, especially when done gradually. Short covering becomes a short squeeze when the buying pressure is intense and rapid, leading to a significant and self-reinforcing price surge.
The key difference lies in the scale and speed of buying activity. Short covering is a controlled process with little impact on the overall market price, while a short squeeze involves a sudden surge in buying that can dramatically drive up the price.
Short Squeeze vs. Pump-and-Dump Schemes
Pump-and-dump schemes involve artificially inflating the price of an asset through misleading or exaggerated information, creating a false sense of demand. Once the price has been "pumped" up, the orchestrators of the scheme "dump" their holdings, leaving other investors with losses.
Unlike short squeezes, which are driven by market dynamics and forced buying from short-sellers, pump-and-dump schemes are deliberate attempts to manipulate the market through misinformation and coordinated trading activity.
Short Squeeze vs. Breakouts
Breakouts occur when the price of an asset moves decisively through a significant support or resistance level, often accompanied by a surge in trading volume. Breakouts can signal a potential shift in market sentiment and the beginning of a new trend.
While breakouts can lead to rapid price increases, they differ from short squeezes in their underlying cause. Breakouts are driven by genuine shifts in market demand and supply, often supported by strong trading volume and consistent price action. Short squeezes, on the other hand, are primarily fueled by forced buying from short-sellers, which may not be sustainable in the long term.
Example of a Short Squeeze
The 2021 GameStop short squeeze, where retail investors coordinated to drive up the price of the heavily shorted stock, had a ripple effect on the cryptocurrency market, particularly on Dogecoin (DOGE). As the GameStop saga unfolded, retail investors, fueled by social media sentiment and a desire to challenge traditional financial institutions, turned their attention to Dogecoin, pumping its price from $0.0041 in January 2021 to over $0.50 in May 2021.
How to Spot an Impending Short Squeeze
Short Interest: Monitor the short-interest ratio, which compares the number of shares sold short to the total number of shares outstanding, to gauge the level of short-selling activity.
Days to Cover: A high "days to cover" suggests that short-sellers might face difficulties exiting their positions quickly, increasing the likelihood of a short squeeze.
Relative Strength Index (RSI): The RSI is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions.
A high RSI above 70 indicates an asset is overbought and potentially due for a correction. However, in the context of a short squeeze, a high RSI can also signal strong buying pressure, which might fuel further price increases and exacerbate the squeeze.
How to Trade Cryptocurrencies on Flipster
Sign up for an account on the Flipster website or by downloading the Flipster app (Android or Apple).
Click the [Trade] tab.
Search for your preferred cryptocurrency and click on it.
Select the leverage (up to 100x).
Select either a Trigger Order or Market Order.
Enter the amount of coin you want to trade or choose a percentage of your available funds.
Once you have confirmed the details, click the [Long] or [Short] button to open a position.
Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.