How terrifying is shorting? Understanding the essence of shorting and practical strategies to deal with it

Many investors know that shorting can make quick money, but few truly understand the power of a short squeeze. A short squeeze is like an invisible fuse that can instantly cause heavy losses for short sellers, even wiping out their principal.

What is a Short Squeeze? A Nightmare for Short Sellers

Simply put, a short squeeze occurs when short positions are forced to cover. When you short a stock, expecting it to fall, but instead the price rises, leading to margin calls, and your broker forces you to buy back at a higher price to cut losses. Even more frightening, a large number of short positions covering simultaneously can push the stock price even higher, creating a vicious cycle.

There are three main ways to short, each with its own risks:

Borrowing stocks to short: Borrowing shares from a shareholder and selling them, then buying back when the price rises. The risk is unlimited—the price can go as high as it wants, and you must buy back at a loss.

Futures shorting: Posting margin to open a short position, with rollover requirements. If the market surges sharply, your margin can quickly become insufficient, leading to forced liquidation.

CFD contracts: Using leverage to trade price differences, offering flexibility, but also carrying the risk of margin calls and liquidation.

Why Do Short Squeezes Occur? Unveiling the Market’s Hunting Game

Short squeezes usually happen in two scenarios: one, speculators or large institutions deliberately target stocks with high short interest; two, a sudden improvement in a company’s fundamentals triggers natural buying.

Case 1: WSB Battle with Wall Street over GME Short Squeeze

In late 2020, Canadian entrepreneur Ryan Cohen bought GME and joined its board. Rumors spread, and the stock price jumped from single digits to $20. Wall Street quickly issued reports claiming GME was severely overvalued and heavily shorted. The short interest reached an astonishing 140% of the total shares outstanding.

This news ignited Reddit’s WSB forum, where retail investors united to go long. In just two weeks in January 2021, GME soared from $30 to $483, a gain of over 1500%. Short sellers lost more than $5 billion in this squeeze, and the stock price then plummeted by 80% shortly after.

Case 2: Fundamental Short Squeeze in Tesla

TSLA went from consecutive losses to profitability by 2020, with explosive growth at the Shanghai Gigafactory, causing its stock to rise sixfold in six months, followed by a stock split. In just two years, the stock price increased nearly 20 times, making it a classic fundamental-driven short squeeze case.

What to Do When Facing a Short Squeeze?

If you already hold short positions, the most important thing is to survive and exit. Here are two practical principles:

Cut losses immediately at high risk moments: When short interest exceeds 50% of the circulating shares, even if the price is still falling, you should close your position early. Watch the RSI indicator; when it drops below 20, indicating oversold conditions, the risk of reversal is high. You must close your position immediately. Small losses or gains are much better than getting caught in a short squeeze.

If you decide to participate in a short squeeze: Keep an eye on changes in short interest. As long as short positions are increasing, there’s a chance to push the price higher. Once signs of short covering appear, take profits immediately. Since the price movement is driven by market sentiment rather than fundamentals, it can be extremely volatile and fierce when reversing.

How to Avoid Short Squeezes and Safely Short for Profit

Short squeezes generally require two conditions: excessive short interest and high market attention. Therefore, choosing major indices or large-cap stocks is safer, as their high liquidity makes extreme short interest unlikely.

In a bearish market, it’s best to wait for a rebound before shorting. Borrowing stocks to short is not recommended due to the risk of forced buy-ins. Using CFD contracts offers more flexibility, allowing investors to control leverage ratios themselves.

An advanced strategy is balancing stocks and bonds: long positions in individual stocks while shorting the market index, with a 1:1 ratio. As long as individual stocks outperform the index or decline less, you can achieve steady profits while avoiding the risks of a one-sided short squeeze.

Final Advice

A short squeeze is like a black swan for short sellers—one event can wipe out all the gains accumulated on a platform. Always remember: how high a stock can rise, it can also fall deep. While monitoring market movements, pay close attention to fundamental and news developments; a single piece of bad news can ruin your position. Shorting is always a game of “limited gains, unlimited risks.” Staying alive is the key to winning.