A short squeeze happens when the price of an asset sharply increases due to a lot of short sellers being forced out of their positions.
Short sellers are betting that the price of an asset will decline. If the price rises instead, short positions start to amass an unrealized loss. As the price goes up, short sellers may be forced to close their positions. This can occur via stop-loss
contracts). It can also happen simply because traders manually close their positions to avoid even greater losses.
So, how do short sellers close their positions? They buy. This is why a short squeeze results in a sharp price spike. As short sellers close their positions, a cascading effect of buy orders adds more fuel to the fire. As such, a short squeeze is typically accompanied by an equivalent spike in trading volume
Here’s something else to consider. The larger the short interest is, the easier it is to trap short sellers and force them to close their positions. In other words, the more liquidity
there is to trap, the greater the increase in volatility may be thanks to a short squeeze. In this sense, a short squeeze is a temporary increase in demand while a decrease in supply.
The opposite of a short squeeze is a long squeeze – though it’s less common. A long squeeze is a similar effect that happens when longs get trapped by cascading selling pressure, leading to a sharp downward price spike.