In simple terms
A trader who sells short sells borrowed securities and hopes to buy them back at a lower price. If price rises instead, the trader may choose or be forced to repurchase them. Those purchases add demand: when many shorts exit together and liquidity is limited, the rally may accelerate. This feedback loop is a short squeeze.
How it develops
News, ordinary buying, or scarce supply may start the move. Higher prices increase short sellers' losses; margin requirements, risk limits, or a recall of borrowed shares may trigger further covering. The mechanism weakens when positions have been reduced, new supply appears, or the initial demand fades.
Useful evidence includes short interest, days to cover, stock-loan cost and availability, volume, liquidity, and actual changes in positioning.
Limit
A heavily shorted asset that rises is not automatically undergoing a short squeeze. In the 2021 GameStop episode, the SEC staff report examined short covering alongside broader buying activity; attributing the entire move to one cause would be inaccurate.
Sources
- Investor.gov, Short Sales — explains borrowing, selling, repurchasing, and the potentially large risk of a short position.
- U.S. SEC, Staff Report on Equity and Options Market Structure Conditions in Early 2021 — analyzes GameStop and distinguishes short covering from other observed buying.
- FINRA, Know What Triggers a Margin Call — explains how margin requirements and broker-imposed sales may affect financed positions.