The record number of speculators shorting the euro were feeling the pain on Tuesday as exchange traded funds pegged to the currency’s movements against the U.S. dollar rallied nearly 1%.

CurrencyShares Euro Trust (NYSEArca: FXE) gained 0.9% in midday trading.

“Hedge funds increased their bets against the euro to a record level in the last week of 2011, increasing pressure on the embattled European common currency as it enters the most testing year of its history,” the Financial Times reported. “Many hedge funds lost money betting against the euro for much of last year, as the currency remained unexpectedly strong despite the continent’s worsening financial crisis.”

With so many traders shorting the euro, the potential exists for a “short squeeze” if the euro strengthens and investors scramble to cover. Traders who short a stock or security profit when the price declines.

“Typically when everybody and their grandmother has piled into a trade, it’s a good time to start thinking about moving in the other direction,”’s MarketBeat reported last month. [The Contrarian: Euro ETFs]

CurrencyShares Euro Trust lost about 3% in 2011. [ETF Chart of the Day: Dollar, Euro Currency Funds]

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