What is short squeezing? An in-depth analysis of short-term crises and how to respond

In financial markets, investors face risks not only from deteriorating fundamentals but also from hidden market liquidity hazards—short squeezes. This market phenomenon appears full of opportunity but conceals significant danger. Many short sellers, failing to recognize the power of a short squeeze in time, end up suffering heavy losses or being forced out at a huge cost. What exactly is a short squeeze? And how should one respond to this short-term crisis?

The Essence of a Short Squeeze: Chain Reaction Triggered by Forced Covering

A short squeeze occurs when the price of a stock or other financial asset rapidly rises, forcing short sellers—who lack sufficient margin—to buy back all their short positions at higher-than-expected prices to close their trades. Simply put, it’s about forcing short investors to cover.

Three Ways to Short

To understand the power of a short squeeze, first grasp how investors short assets:

1. Borrow Stocks from Brokers to Short Sell
Investors borrow stocks from long-term shareholders, pay interest, and sell. When the stock price falls, they buy back at lower prices to profit from the difference. The risk here is that if the stock keeps rising, they face increasing interest costs and the threat of forced covering.

2. Use Futures for Reverse Trading
Investors deposit margin to open futures short positions. This method offers fixed leverage but requires periodic rollover. If the stock price surges beyond expectations, margin calls may occur.

3. Use CFD Contracts
Contracts for Difference (CFDs) are derivatives allowing investors to control leverage freely. Compared to borrowing stocks, CFDs do not involve forced covering, but margin risk remains.

Regardless of the method, when prices keep rising, short sellers face a common problem: margin calls leading to forced liquidation. This results in large volumes of short positions being bought back, pushing prices even higher—a vicious cycle. This is the core mechanism of a short squeeze.

Why Do Short Squeezes Occur? Understanding the Underlying Logic

Short squeezes are not accidental; they typically require two conditions: a high proportion of short interest + a surge in market attention.

Specific Events Driven by Active Manipulation

GME (GameStop) Short Squeeze—Retail Investors vs Wall Street Institutions

During the 2020 pandemic, Canadian entrepreneur Ryan Cohen heavily bought GME shares and joined the board, aiming to revive the struggling game retailer. This news drove the stock from single digits to nearly $20.

However, Wall Street institutions viewed GME as overleveraged, outdated, and severely overvalued, issuing bearish reports and heavily shorting. Due to low trading volume, these institutions borrowed shares amounting to 140% of GME’s float—a dangerously high level.

The turning point came on Reddit’s WallStreetBets forum. Nostalgic retail investors united to buy GME shares, fighting against the short sellers. On January 13, 2021, the stock surged 50% in a day to $30. Within two weeks, it soared to an astonishing $483, a 16-fold increase.

Massive short positions, due to margin shortages, were forcibly covered by brokerages, with media estimating losses exceeding $5 billion for short sellers. Afterwards, the stock price plummeted rapidly, dropping over 80% within a week.

Following this event, speculative funds shifted to heavily shorted companies like AMC and BlackBerry, experiencing sharp rises and falls in the short term.

Fundamental Changes Leading to Natural Short Squeezes

Tesla’s Electric Vehicle Rise

Compared to GME’s manipulation, Tesla’s case shows how fundamental shifts can trigger a short squeeze.

After Elon Musk took over Tesla, despite launching new models, sales remained lackluster, and the company suffered continuous losses, making it a prime target for short selling. At one point, Tesla had the highest short interest among stocks.

In 2020, a turning point: Tesla posted its first full-year profit, with Shanghai Gigafactory contributing revenue. The stock soared from around $350 to $2,318, nearly a 6.6-fold increase. A 1-for-5 stock split did not slow the rally; within a year, the price climbed from over $400 to above $1,000.

In just two years, Tesla’s stock price increased nearly 20 times, causing enormous losses for short investors. This is a classic example of a fundamental improvement driving a stock’s rise, aided by global QE policies in 2020.

Preconditions for a Short Squeeze

Both cases point to a common reason: excessive short interest leading to market illiquidity. When a stock’s short interest exceeds 50% of the float, any upward movement can trigger a chain reaction, resulting in a large-scale short squeeze.

How to Respond to a Short Squeeze?

If you have a short position and suddenly see the market squeezing, how can you protect yourself?

Two Main Strategies for Investors Facing a Short Squeeze

Strategy 1: Exit Conservatively When Short Interest Is Over 50%

When you notice a stock’s short interest exceeds 50% of the float, even if the price is still weak, consider closing your short early. The risk now outweighs potential gains.

You can use RSI (Relative Strength Index) as a reference:

• RSI 20-50: Bearish momentum dominates; suitable for shorting
• RSI 50-80: Bullish momentum increases; risk of short squeeze rises
• RSI below 20: Oversold condition, prone to reversal; consider closing positions immediately

For short sellers, once RSI drops below 20, it indicates the market is in an irrational zone. The likelihood of a reversal is high, and holding on is akin to gambling.

Strategy 2: For Those Wanting to Participate in a Short Squeeze

If you aim to go long during a short squeeze, monitor short interest closely. When short interest continues to rise, you might consider going long; but once large-scale short covering begins, stop gains immediately.

Participation in a short squeeze is essentially betting on covering shorts, not on company fundamentals. When the squeeze ends, these buying pressures vanish, and prices often fall back sharply.

How to Avoid Short Squeeze Risks and Safely Short

Since a short squeeze requires excessive short interest + surging market attention, how can investors avoid risks when shorting?

Choosing Suitable Trading Assets

Prioritize large-cap indices or blue-chip stocks

Major indices like S&P 500 futures or NASDAQ are too large for short interest to reach dangerous levels. Their liquidity prevents extreme short interest, making short squeezes unlikely.

Preferred Trading Methods

CFD Contracts Over Borrowed Stocks

CFDs offer:

• No forced covering risk
• Self-controlled leverage
• More flexible risk management

Borrowing stocks for shorting can lead to forced liquidation during rapid price surges, whereas CFDs provide more control.

Hedging Strategies

Use Long-Short Portfolios

A safer approach:

• Hold long positions in quality stocks
• Short major indices for hedging

If your long/short ratio is 1:1, you profit if:

• Stock rises more than the index
• Stock falls less than the index

This reduces systemic risk and maintains profit potential regardless of market swings.

Timing Your Trades

In bearish markets, wait for rebounds before shorting, avoiding chasing falling knives. This prevents being caught in potential fundamental recoveries.

Summary: Short Squeeze Risks Are Ever-Present

A short squeeze is one of the most destructive risks in short trading. It offers limited upside but unlimited downside: profits are capped at the stock’s zero, but losses can be infinite.

Investors must constantly monitor short interest levels. Whether using stocks, futures, or CFDs, timely risk management and decisive stop-loss execution are crucial.

Short squeezes will continue to appear in markets. Instead of passively suffering losses, understanding their mechanics and establishing defensive strategies allows you to seize shorting opportunities while avoiding catastrophic squeezes.