In the forex markets, a short squeeze occurs when there is excess demand and lack of supply from traders for a particular currency pair. Due to this excess demand, prices continue to rise rapidly. Traders who hold short positions try to hedge their positions, an operation which can only be done through a buy transaction. As the number of traders looking to buy increases, the price rally increases accordingly.
In the forex market, a short squeeze normally occurs after a strong sharp move and close to a reversal. Suppose, for example, that the GBP / USD currency pair has experienced a long-term downtrend. At some point, some traders may feel that the pound is undervalued, and begin to believe that it can be a good investment. As more and more traders enter the market to buy, those who hold short positions in sterling decide it is best to close their positions, in order to avoid taking losses. This means that more and more traders will buy pounds and that all short positions will be excluded from the market.