Jim Woods

Blame It On a Short Squeeze

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Options traders are acutely aware of the tremendous run in stocks we've witnessed over the past nine weeks. The virtually unabated move higher in the equity markets finally hit a roadblock this week, but for more than two months, the bull run has trampled many a short position.

Part of why we've seen stocks surge so high over these two-plus months is likely a phenomenon known as the "short squeeze."

You've probably heard this term bandied about in the financial press whenever stocks go up inexplicably. Hey, if you don't know why the market is moving higher, many experts just blame it on a short squeeze.

But just what is a short squeeze, and how does it drive stock prices higher?

A short squeeze happens when the price of a stock rises quickly, prompting shorts to run and "cover," which simply means they must buy the stock in the open market to repay the shares they have borrowed on margin.

This flood of buying has the effect of generating higher prices, which in turn prompts more people to sell and take a profit. This action leads to brokers calling in more loans, which then forces many short sellers to go into the open market to cover their loans.

As OptionsZone shorting guru Michael Shulman says, "Short-squeezes can be ferocious, can last quite a while, and can be very expensive."