What is short squeezing? Analyzing the biggest nightmare for bearish investors

The concept of a short squeeze is unfamiliar and intimidating to many investors. In the pursuit of profits, many choose to short sell to counteract declining markets, but often find themselves caught off guard by a short squeeze. What exactly is a short squeeze, why does it become a nightmare for short sellers, and how can you respond? This article will take you deep into the most damaging phenomenon in the financial markets.

The Essence of a Short Squeeze: Why Short Positions Turn into Time Bombs

A short squeeze, also known as “嘎空,” refers to the phenomenon where, as the price of a shorted asset rapidly rises, short investors are forced to buy back at high prices, further driving up the asset’s price. In simple terms, it’s about forcing short covering.

To understand why a short squeeze occurs, you need to first understand how short selling works. Investors mainly have three ways to short: first, borrowing stocks from long-term shareholders, paying interest, and selling, then buying back when the price drops; second, using futures or CFDs (contracts for difference), posting margin to short; third, similar to futures but CFDs do not require rollover.

Regardless of the method, once the stock price starts rising, the margin of short sellers faces erosion risk. If the rise is fierce and the margin becomes insufficient, brokers will forcibly close positions. When a large number of short positions are forced to cover, these “covering buy orders” push the price even higher, creating a self-reinforcing cycle — this is the terrifying aspect of a short squeeze.

Short squeezes can be categorized into two types: one is when the stock price rebounds too quickly, forcing shorts to buy back at high prices; the other involves groups with manipulation ability rapidly inflating the stock price, forcing shorts to buy at inflated prices, allowing the group to reap huge profits. The latter carries far higher risks than the former.

Manipulation-Driven Short Squeeze: Classic Battles Between Wall Street and Retail Investors

The most famous short squeeze case is the 2021 GME incident — this “retail vs. Wall Street” battle changed many people’s perceptions of the financial markets.

GameStop (GME), once a declining gaming retailer, continued to fall during the 2020 pandemic. In September, Canadian entrepreneur Ryan Cohen heavily bought GME shares and joined the board, aiming to revamp the company. This news energized the market, pushing the stock from single digits to nearly $20.

However, many Wall Street firms issued reports claiming GME was severely overvalued and recommended shorting. Due to GME’s small market cap and limited float, these institutions began borrowing shares to short. Shockingly, the short interest reached 140% of GME’s total shares, far exceeding the available float. Every short investor believed the company would eventually fall back to its original price, waiting patiently to profit.

But this triggered Reddit’s stock forum WS B (Wall Street Bets). The community, outraged, saw GME as a childhood memory and decided to band together to buy shares, forcing Wall Street to “lose.” On January 13, 2021, the stock surged 50% to $30, and within two weeks, hit a peak of $483 on January 28.

The insane rise in stock price caused margin calls for shorts, forcing them to buy back at sky-high prices. Media reports indicate that shorts lost over $5 billion in this event. A week later, the stock price plummeted over 80% from its peak by February 2.

Following the event, WS B members continued to hype stocks like AMC and BlackBerry, which had high short interest, causing these stocks to spike sharply and then quickly fall back. These series of events are still regarded as some of the most iconic short squeeze storms in recent times.

Natural Short Squeeze: How Fundamental Reversals Defeat Short Sellers

Not all short squeezes stem from manipulation; sometimes genuine improvements in fundamentals trigger a squeeze. Tesla is a typical example.

As a leader in electric vehicles, Tesla showed ambition under Elon Musk, but with limited long-term sales and consecutive losses, it was once seen as overhyped. However, investors remained optimistic about EVs’ future, and the stock price kept rising. Due to Tesla’s large market cap and liquidity, it became one of the most heavily shorted stocks.

The turning point came in 2020. Tesla turned profitable, with explosive revenue from its Shanghai Gigafactory, causing the stock to soar. In just half a year, the price rose from $350 to $2,318, nearly a 7-fold increase. After a 5-for-1 stock split, the price climbed from over $400 to over $1,200 (peak at $1,243), a 20-fold increase in two years, causing severe losses for short investors.

This is a classic case of a genuine fundamental turnaround triggering a short squeeze. The astonishing gains were also closely related to the abundant liquidity from global QE (quantitative easing) policies in 2020.

How Traders Can Protect Themselves During a Short Squeeze: Essential Response Strategies

Short selling is like robbing a bank — a safe exit is the most important. The profit ceiling for shorting is zero (stock price going to zero), but losses are unlimited. When caught in a short squeeze, prices can rise several times or even dozens of times in a short period, making short selling a “limited profit, unlimited risk” strategy.

How can you protect your capital when a short squeeze occurs? Based on market experience, traders can adopt the following two strategies:

Strategy 1: Cut Losses Decisively When Short Positions Are Over 50% of Float
When short interest exceeds 50% of the float, even if the stock remains weak, it’s advisable to close positions early. Don’t be greedy; small profits or small losses are acceptable. Monitor market sentiment and RSI indicators. RSI between 50–80 indicates bullish strength; between 20–50 indicates bearish strength.

Most importantly, when RSI drops below 20, it indicates an oversold condition, suggesting the market is leaving rationality, and a reversal is highly likely. To avoid being caught in a short squeeze, exit promptly.

Strategy 2: Monitor Short Interest When Participating in a Short Squeeze
If you want to actively participate in a short squeeze for high gains, you must closely watch short interest changes. If short interest continues to rise without covering, it can push prices higher; but once signs of short covering appear, take profits immediately. Otherwise, once the squeeze ends, prices will quickly revert to reasonable levels.

Note that these buying pressures are not driven by genuine confidence in the company’s fundamentals but are purely “covering buy orders” to support inflated prices. Therefore, both upward and downward movements can be extremely volatile.

How to Avoid Short Squeeze Traps: Defensive Strategies to Reduce Short Selling Risks

A short squeeze typically requires two conditions: excessive concentration of short interest and high market attention. Understanding these helps investors avoid risks in advance.

For those intending to short, it’s best to prioritize large-cap indices or blue-chip stocks. These assets, with high liquidity, are less prone to excessive short interest concentration.

In a bear market, patience is key — wait for market rebounds before shorting. Generally, borrowing stocks to short is not recommended due to the risk of broker forced buy-ins; using CFDs with margin is more suitable. CFDs allow flexible leverage and better risk management.

Investors can also hedge to reduce risk: for example, go long on stocks while shorting the broader market. A 1:1 ratio of positions means that if the stock outperforms the market in gains or underperforms in declines, profits can be realized. This approach effectively balances short squeeze risks.

For those interested in related trading, choose regulated platforms with high leverage support and low trading barriers.

Finally, all short investors should remember: short squeeze events can cause enormous losses. It’s crucial to monitor order book movements closely and stay updated on fundamental and news developments. Sometimes, a single positive news can wipe out a short position. Remembering the risks of a short squeeze is key to long-term survival for short sellers.