There's Evidence A Giant Short Squeeze Is Happening In The Stock Market

According to Goldman Sachs, a big part of the 3 percent rally in the S&P 500 this past week was the result of a large short squeeze in some of the areas of the market that have been the worst-performers in recent months.

Earlier this week, Goldman analysts noted a nearly 6 percent rise in the 50 most heavily-shorted stocks in the Russell 3000 Index.

What Is A Short Squeeze?

When traders want to make a bet that the price of a stock will go down rather than go up, they can make a short sale of the stock. An investor makes a short sale of a stock by selling borrowed shares of stock in the hopes that those shares can be bought back for a lower price in the future, and the short seller can pocket the difference.

A short squeeze occurs when a group of short sellers close (or "cover") their short positions in a heavily-shorted stock all at once by buying back shares. The demand for shares from short covering drives the share price higher, often leading to more short covering.

Evidence Of A Short Squeeze

The battered Energy sector is the most likely case of a short squeeze last week.

The Energy Select Sector SPDR ETF XLE, down nearly 16 percent over the past six months, rallied more than 6 percent.

Oil is a particularly interesting case. The United States Oil Fund ETF USO has spiked over 9 percent during the last five trading days, even after the Department of Energy released inventory numbers indicating that the oversupply of oil is still growing.

Individual names within the oil and gas sector show even stronger evidence of short squeezes. Shares of SandRidge Energy Inc SD, Laredo Petroleum Inc LPI and Denbury Resources Inc DNR, all down more than 45 percent over the past six months, were all up more than 30 percent this week.

Will It Last?

Unfortunately for shareholders, short squeezes tend to be a temporary phenomenon. Oil investors are hoping that the recent reduction in U.S. rig counts means that production will begin to fall soon, but inventory numbers indicate an uphill battle for oil in the short term.

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