What is a Short Squeeze?

A short squeeze is a situation in which a heavily shorted Forex pair (or any instrument) moves sharply higher, forcing short sellers to close out their short positions and adding to the upward pressure on the market. Short sellers are being squeezed out of their short positions, usually at a loss. Short squeezes are generally triggered by a positive development that suggests the pair may be embarking on a turnaround. Although the turnaround in the pair's fortunes may only prove to be temporary, few short sellers can afford to risk runaway losses on their short positions and may prefer to close the position even if it means taking a substantial loss.

Short Squeeze Basics

A short squeeze is a risk associated with short selling. If an FX pair starts to rise rapidly, the trend may continue to escalate because the short sellers will likely want out. For example, if the GBPUSD rises 2% in one day, those with short positions may be forced to liquidate and cover their position by purchasing that same pair. If enough short sellers buy back the pair, the price is pushed even higher.

Two measures useful in identifying forex pairs at risk of a short squeeze are short interest and the short interest ratio. Short interest refers to the total number of contracts sold short as a percentage of total contracts outstanding. The short interest ratio is the total number of contracts sold short divided by the pair’s average daily trading volume.

When short interest is very high, or at least higher than what is normal for a pair, it could result in a short squeeze because it is possible that everyone who wants the pair to go down has already taken a position. For example, if short interest for EURUSD is 35%, and 30% is already a high number of short-sellers for that pair, then a larger than usual number of people have placed their trades on the EURUSD going down. If instead, the EURUSD rises, because there is no one left to sell or short, then the price could rise rapidly as the large group of short sellers scramble to exit their short positions by buying.

Betting on a Short Squeeze

Contrarian investors look for markets with heavy short interest because of the short squeeze potential. A rapid rise in the market's price is attractive, but it is not without risks. The market may be heavily shorted for good reason, such as it has a dismal future outlook.

Investors who bet on a short squeeze occurring may accumulate long positions, typically while getting confirmation from other technical price patterns or indicators, or positive fundamental data.

Active traders will monitor highly shorted market and watch for them to start rising. If the price begins to pick up momentum the trader jumps in to buy, trying to catch what could be a short squeeze and a significant move higher.

Risks of Trading Short Squeezes

There are many examples of pairs that moved higher after they had a heavy short interest. But there are also many pairs that are heavily shorted and keep falling in price. A heavy short interest does not mean the price will rise. As indicated, a heavy short interest is often just an indication that the market is doing poorly or people don't believe it is has a strong future.

This is why people who buy in the hopes of a short squeeze happening typically have other analysis which indicates the price of the market should go higher anyway.

Another thing to keep in mind is that a short squeeze can be brief. It may result in a temporary move higher in price, which is then quickly reversed by people who use the higher price as an opportunity to sell.