Short squeeze: A beginner's guide

By Kraken Learn team
10 min
9 Eki 2024
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Understanding market mechanics ⚙️

  • A short squeeze is a sharp spike in price with the expressed intention of forcing short sellers to close or “cover” their positions.

  • They tend to occur when a disproportionate number of traders are positioned short, representing an opportunity to generate liquidity or drive the price up. 

  • Short squeezes are relatively common in crypto, often liquidating billions of dollars of open interest, but there are steps short sellers can take to protect themselves.

A short squeeze is simply a big, impulsive move up in price that forces short sellers - traders betting on the price going down - to close or “cover” their positions. 

To understand the mechanics of a short squeeze, let’s explore what being a short seller means - a concept that is sometimes misunderstood.

How does a short squeeze work? 📊

In any cryptocurrency market, as a trader, you essentially make a bet as to whether you think the price will go up or down. In derivatives markets, if you think the price will go up, you may decide to enter a long position, which amounts to buying contracts that go up in value if the price of the underlying asset increases.

But how do you bet that price will go down if you don’t own a digital asset? If you think the price of Bitcoin (BTC) will go down, but you don't have any to sell, how do you express your bearish view? This is where short selling comes in.

Short squeeze vs short selling

Derivatives contracts allow you to bet on bearish price action by borrowing contracts from a trading platform, and then selling them.

Unlike borrowing money from a bank, there’s no application involved; as long as you have sufficient collateral in your account, you can oftentimes borrow contracts at the click of a button.

These contracts can then be sold using a limit or market order, enabling traders to profit from price going down. The difference between the price sold and the closing price is used to calculate any gains, before fees.

Returning to short squeezes, crucially, to close their position, short sellers have to buy back the contracts they sold. Therefore, when price quickly spikes, it creates a chain reaction, forcing progressively more short sellers to cover. This in turn generates more buying activity, which pushes the price up (and so on). The higher price goes, the more pain is inflicted on short sellers.

The role of short sellers

Generally speaking, the role that every market participant plays is providing liquidity, and short sellers are no different. 

While a short squeeze might appear like an unethical practice — forcing other traders to lose money — it plays a pivotal role that is the lifeblood of financial markets. 

When short sellers cover, it enables other traders to enter positions. This is really important. 

It's this liquidity that drives markets, enabling many players to participate. By casting their vote, short sellers also contribute to price discovery, reducing volatility and keeping an asset closer to a fair price.

Short squeeze example

Let’s imagine that a trader is looking to short 10 Bitcoin (BTC) after a sustained period of bearish price action. With enough collateral in their wallet, they submit a market order to sell 10 contracts, each representing 1 Bitcoin.

By doing so, they have effectively borrowed the contracts from the trading platform, sold them, now hoping to buy them back for less, pocketing the difference as profit. 

But on this occasion, the trader is about to witness a short squeeze. Before this occurs, there were a few warning signs that might have helped the trader avoid getting trapped:

  • Bearish sentiment has reached extreme levels but has started to shift.

  • Large volumes of Tether (USDT) are being moved onto trading platforms.

  • Price has been in a sustained down trend for a long time, but the move is visibly starting to lose steam into an area of support.

  • Open interest has been increasing as price has been descending, which may mean that short sellers are piling in, though this is not clear.

  • Futures funding rates have been consistently and significantly negative for some time, and have continued to increase while price has stalled.

  • Just prior to the reversal, there is a divergence between the Cumulative Volume Delta (CVD) and price, suggesting that aggressive sellers are having a diminishing impact.

Shortly after entering the position, the price of Bitcoin starts to spike violently as does the number of short positions being liquidated. As buyers are now becoming the aggressors, the move corresponds with a clear rise in CVD. 

On this occasion, the trader does not have a stop loss in place and price quickly reaches their liquidation price. As a result, their position is forcibly liquidated, meaning that 10 contracts are bought at the market price. 

With more and more short positions being forced to cover, it creates a cascading effect, quickly and violently driving the price up. With so many active positions being closed, open interest - representing net positioning - is now significantly lower than when the move started. 

black swan event crypto

Key factors that cause a short squeeze 📋

There are few factors that can drive a short squeeze. Learning these can help crypto traders better the market and potentially anticipate when these events may occur.

Market Imbalances

While it’s never the case that there are more shorts than longs - for every long position, there is always a corresponding short position - the flow of orders can offer us some insight into directional bias, and whether it’s short sellers who are the aggressors. 

Specifically, open interest and funding rates often serve as proxies for market sentiment and short selling activity (more on this below). Short sellers are particularly vulnerable to being squeezed when:

  • They have been the aggressors for a prolonged period, but their aggression is no longer being rewarded (i.e. funding is negative, but price is stalling).

  • There has been a prolonged downward move and sentiment has bottomed out - bears are complacent.

Generally speaking, financial markets seek to restore balance, and tend to apply pressure when one side of the market is vulnerable to exploitation. 

Want to know more about futures trading? Kraken has an extensive range of video guides for beginners to help you get started.

News

News flow can be a significant source of volatility, even if any upside is short lived. The price of Hedera (HBAR) famously pumped 96% in one day after the misinterpretation of a BlackRock announcement.

Bullish momentum

Sustained strength from buyers can climax in an impulsive move to the upside, resulting in the liquidation of short interest. At any moment, without warning, a large buyer can enter the market with any size, catching many participants off guard.

Liquidity

Thinly-traded markets are particularly vulnerable to short squeezes, as it takes a comparatively small amount of buying activity to drive the price much higher. 

Sometimes, traders accidentally spike the price of a digital asset in what’s known as a “Fat Finger”. The price of Bitcoin (BTC) crashed 87% in 2021 on Binance.US - the result of a “misplaced decimal point”. Crypto assets with less liquidity are much easier to manipulate, as evidenced by numerous “pump and dump” schemes seen in the space.

Hedge funds and short squeezes 🏦

Hedge funds play an active role in crypto markets, and as with other market participants, are not immune to short squeezes.

Hedge funds recently took advantage of the basis trade in Bitcoin - profiting from the difference between CME futures and spot prices. Because of the way that short interest is reported in trad-fi markets (the Commitment of Traders report identifies different categories of participants and their positioning), many hedge funds positioning themselves short could increase the likelihood of a targeted short squeeze.

Hedge funds short squeeze

Real-life examples of crypto short squeezes 📖

Here are some famous examples of crypto short squeezes:

How traders can navigate crypto short squeezes 🧑🏽‍💻

  1. Employ robust risk management and use a stop loss. Many short sellers get liquidated simply because they fail to have any protective stop. If you are using cross margin without a stop loss, you may risk losing all of your capital if price moves violently against you. 

  2. Incorporate futures indicators into your analysis. By combining data from open interest, funding rates, long/short ratios, liquidation data and net position changes, you may gain some insight into whether shorts are likely to be squeezed. Making such judgements requires discretion and some level of expertise, and cannot be meaningfully covered in this article. If you are interested to see what this data looks like, resources such as Coinglass and Velo allow users to track various metrics in derivatives markets. There are also several free newsletters you can subscribe to that offer a breakdown of futures positioning and any anomalies. 

  3. Monitor the news. While FX markets have daily news events that are a constant source of volatility, the impact of the same news events in crypto is less clear. Further, crypto has so many individual projects, which are subject to their own developments, it’s critically important to stay informed about the digital asset you are trading. 

In summary, short squeezes pose a significant risk to traders in cryptocurrency markets, particularly when short sellers have been the aggressors for an extended period. However, by taking some basic steps, traders can mitigate the risk of being caught off guard.

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Disclaimer

These materials are for general information purposes only and are not investment advice or a recommendation or solicitation to buy, sell, stake, or hold any cryptoasset or to engage in any specific trading strategy. Kraken makes no representation or warranty of any kind, express or implied, as to the accuracy, completeness, timeliness, suitability or validity of any such information and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. Kraken does not and will not work to increase or decrease the price of any particular cryptoasset it makes available. Some crypto products and markets are unregulated, and you may not be protected by government compensation and/or regulatory protection schemes. The unpredictable nature of the cryptoasset markets can lead to loss of funds. Tax may be payable on any return and/or on any increase in the value of your cryptoassets and you should seek independent advice on your taxation position. Geographic restrictions may apply.

Trading futures, derivatives and other instruments using leverage involves an element of risk and may not be suitable for everyone. Read to learn more.