Imagine this scenario: a trader is sitting, enjoying the morning, drinking coffee, and rubbing their hands with joy because they opened a short position on Bitcoin. A short is a bet that the price of an asset (like Bitcoin) will go down. The trader believes that the cryptocurrency is currently overvalued and that a decline is imminent, after which they will be able to buy the cheaper asset and make a profit. But suddenly... BANG! The price goes up - sharply and unexpectedly. Panic ensues in the market, and this marks the beginning of the phenomenon known as a short squeeze.
How does a short squeeze work?
To understand what a short squeeze is, let's first figure out how shorts (short positions) actually 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 and buying price constitutes the profit. However, if the price unexpectedly starts to rise, the trader finds themselves in a difficult position: their losses also begin 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 rising demand pushes the asset's price even higher! It's something like a snowball effect: the more people close their shorts, the higher the price goes.
How can a short squeeze trigger mass panic?
Now imagine this happening with Bitcoin or another popular cryptocurrency. Major players or groups of traders might deliberately create a 'pump' - a mass purchase of an asset - to provoke a price increase. When the price goes up, short sellers are forced to close their positions and buy Bitcoin to limit their losses. This mass buyback pushes the price even higher, and as they say, away we go: the short squeeze is in full swing.
As the price skyrockets, short sellers start 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 a matter of minutes, especially 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 the 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' - major market players who have enough capital to coordinate purchases and drive the price up. They may notice that there are many short positions in the market and then deliberately start buying to set off that very domino effect.
A short squeeze is a perfect example of how emotions, psychology, and strategies intertwine in a single process in financial markets. When traders rush to close their shorts en masse, 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. So the next time you see an asset's price soar against expectations, know this: it might just be a short squeeze that has skillfully shaken the unfortunate bears (short sellers) out of the market and gifted profits to the brave bulls!
