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A short squeeze happens when there is excess demand and a lack of supply for a particular financial security.

What happens is that due to the excess demand, prices continue to rise rapidly. Traders holding short positions try to cover their positions (i.e. close their positions), which can only be done by by buying. With more and more traders looking to buy, we normally see an extended rally as prices go higher and higher. In this sense, all the “shorts” are squeezed.

In the forex market, a short squeeze normally happens after a strong sharp move and we see a reversal.

For example, EUR/USD went on a long term down trend. At a certain point, some traders may feel that the euro is undervalued, making it a good investment. As more and more buyers enter the market, traders holding short euro positions decide it would be best to close out their positions or potentially suffer losses. This leads to more and more traders buying the euro, and all the short positions getting squeezed out of the market.