Imagine a situation: one of the traders is sitting, enjoying the morning, drinking coffee, and gleefully rubbing their hands because they opened a short position on Bitcoin. A short is a bet that the price of the asset (for example, Bitcoin) will go down. The trader is confident that the cryptocurrency is currently overvalued, and a drop will soon follow, after which they can buy the asset at a lower price and profit. But suddenly... BAM! The price goes up - sharply and unexpectedly. Panic begins in the market, and this marks the start of the phenomenon known as a short squeeze.
How does a short squeeze work?
To understand what a short squeeze is, let's first clarify how shorts (short positions) work. When someone opens a short, they borrow an asset and sell it at the current price, hoping to buy it back later at a lower price. The difference between the selling price and the buying price is the profit. However, if the price unexpectedly starts to rise, the trader finds themselves in a difficult position: their losses also start to grow. And this is where the short squeeze comes into play.
A short squeeze is a situation where the price of an asset sharply rises, forcing traders with short positions to close their trades to avoid even greater losses. But to close a short, they must buy back the very asset they 'borrowed' and sold earlier. This means that the growing demand pushes the asset's price even higher! It creates a snowball effect: the more people close their shorts, the higher the price goes.
How can a short squeeze cause mass panic?
Now imagine this happening with Bitcoin or another popular cryptocurrency. Large players or groups of traders can intentionally create a 'pump' - a mass purchase of the asset - to provoke a price increase. When the price rises, short holders are forced to close their positions and buy Bitcoin to limit their losses. The mass buyback pushes the price even higher, and, as they say, it takes off: the short squeeze spins out of control.
As the price skyrockets, traders with shorts begin to panic and close their positions one by one. This creates not only a financial but also a psychological panic effect. Many traders lose money, sometimes literally in just a few minutes if the asset is particularly volatile. And here’s the result: those who bet on a decline suffer losses, while the bulls (those who believe in a rise) rejoice.
Why is a short squeeze always an unexpected 'surprise'?
A short squeeze often comes as a complete surprise to traders, especially if they had no reason to expect such a sharp jump. For example, sometimes short squeezes are triggered by 'whales' - large players in the market who have enough capital to coordinate buying and push up the price. They may notice that there are many short positions in the market and then intentionally start buying to trigger that domino effect.
A short squeeze is the perfect example of how emotions, psychology, and strategies intertwine in a single process in financial markets. When traders rush to close their shorts, the price continues to rise, turning the short squeeze into an exciting, albeit extremely risky, spectacle.
In the end, a short squeeze is not only a way to understand the nature of market fluctuations but also a great reminder that markets are unpredictable and treacherous. And the next time you see that the price of an asset has soared contrary to expectations, know this: it might just be a short squeeze that cleverly shook the unlucky bears (short sellers) out of the market and rewarded the bold bulls!
An article about the opposite situation in the market - Long squeeze.