What is short selling? A market risk management guide that investors must understand

What Is the Essence of Short Squeeze (Gao Kong)

Many investors have heard of the term “short squeeze,” but few truly understand what a short squeeze is. In simple terms, a short squeeze refers to a phenomenon where the price of a stock or asset that has been heavily shorted suddenly rises, forcing short sellers to buy back shares at higher-than-expected prices to cover their positions, thereby pushing the asset’s price even higher.

There are two scenarios for a short squeeze: one is a natural rise in stock price due to improved fundamentals or a shift in market sentiment, causing short sellers to exit at a loss; the other is when market-dominant funds deliberately boost the stock price to induce short sellers to cover at high prices for quick profits. Regardless of the situation, the core of a short squeeze points to the same outcome—short investors face significant losses.

Understanding Short Selling Mechanisms to Avoid Short Squeeze Risks

Before discussing short squeezes, it’s important to clarify the three common methods of short selling:

Borrowed Stock Short Selling: Borrowing shares from long-term shareholders, paying interest, and buying back shares after the price drops. The risk is that if the stock price rises, investors need to meet margin calls, and in extreme cases, brokers may forcibly close their positions.

Futures Trading: Paying margin to open short positions, requiring periodic rollover. If the stock price surges rapidly, insufficient margin can trigger margin calls or forced liquidation.

Contract for Difference (CFD): Using leverage to trade, with investors able to adjust leverage ratios themselves. The advantage is no need for rollover, but risks remain from sharp price swings.

How Do Short Squeeze Events Occur

Organized market attacks—Analysis of the GME incident

At the end of 2020, Canadian entrepreneur Ryan Cohen purchased GME shares and joined the board. Several Wall Street institutions issued reports claiming the stock was severely overvalued, leading to massive shorting. GME had a small market cap and limited trading volume, with short interest reaching 140% of the total shares—creating a perfect breeding ground for a short squeeze.

The turning point came on Reddit’s WSB forum. Investors saw this as an opportunity to counter hedge fund market manipulation and began collectively buying GME shares. By mid-January 2021, the stock price skyrocketed from around $30 to $483 within just two weeks, creating a market miracle. The insane surge in stock price caused margin calls on short positions to collapse, forcing them to cover at high prices, resulting in over $5 billion in losses for short sellers. Afterwards, the stock price quickly retreated to below 20% of its peak.

Natural short squeeze driven by fundamental changes—Tesla case

Tesla’s short squeeze process was entirely different. When the company was losing money long-term, short sellers believed it was a low valuation trap and heavily shorted. But starting in 2020, Tesla turned losses into profits, with the Shanghai Gigafactory contributing explosive revenue, fundamentally changing the company’s outlook.

As the electric vehicle trend solidified, buying interest naturally surged. The stock price soared from around $350 to $2,318 in just half a year, followed by a 1-for-5 stock split. Subsequently, within a year, the price broke above $1,000 from over $400 (peak at $1,243), with a total increase approaching 20 times. This short squeeze was purely due to genuine fundamental improvement, but for short investors, the outcome was equally devastating.

How Should Investors Respond After a Short Squeeze

Principle 1: Monitor Short Positions

When a stock’s short interest exceeds 50% of the circulating shares, a short squeeze risk has formed. Even if the price continues to decline, consider closing positions early, as the risk now far outweighs potential gains. RSI indicators can assist: an RSI below 20 indicates an oversold market with a high risk of reversal, prompting immediate stop-loss.

Principle 2: Take Profits, Not Greed

If participating in a short squeeze to profit from the trend, closely track short covering activity. As short positions begin to decline, exit immediately. These buying activities are often not based on company fundamentals but are purely for covering. Once the squeeze ends, prices tend to revert quickly to reasonable levels, and profits can evaporate in an instant.

How to Short Successfully and Avoid Becoming a Short Squeeze Victim

Choose the Right Targets: Major indices or large-cap stocks with high liquidity are less prone to high short interest, thus reducing short squeeze risks.

Timing Is Critical: In a bear market, wait for market rebounds before shorting, rather than blindly chasing after falling prices.

Prioritize CFD Trading: Compared to borrowing stocks for shorting, CFDs are easier to manage risk-wise. Investors can adjust leverage freely and set stop-loss orders flexibly.

Advanced Strategy—Hedging: Long individual stocks while shorting the market index. If the stock outperforms the index or falls less, investors profit. This approach effectively balances risk and reduces the impact of short squeezes.

Conclusion

The core characteristic of a short squeeze is “limited gains, unlimited risks.” The maximum profit for short investors is when the stock goes to zero, but during a short squeeze, prices can skyrocket multiple times or even dozens of times in a short period. Therefore, monitoring capital flows, studying company fundamentals, and paying attention to market sentiment shifts are the three key elements for successful shorting. Remember: Safe exit is always more important than greedily earning more.