What does short selling mean? An article to understand the risks of short positions and how to respond

The investment world is unpredictable, and many traders are exploring shorting beyond traditional long positions. It is often said that going long is steady but inefficient, while shorting is quick but fraught with risks. One of the sources of these risks is the “short squeeze” phenomenon, which keeps many short investors awake at night.

The Essence of a Short Squeeze: The Nightmare of Forced Covering

Short Squeeze’s core concept is not complicated—when the price of a shorted asset rises rapidly, short sellers are forced to buy back shares at higher prices to close their positions, further pushing up the price, creating a vicious cycle. In simple terms, it is about forcing short positions to cover unwillingly.

Short squeezes can be categorized into two scenarios. The first is when the stock price rebounds too quickly, and short sellers are forced to close their positions under margin pressure; the second involves capital groups with manipulation capabilities, who rapidly inflate the price to force short sellers to buy at sky-high prices, reaping huge profits.

Before understanding short squeezes, it is essential to grasp the three common methods of shorting:

Method 1: Borrowing Stocks to Short — Borrow stocks from long-term shareholders (pay interest), sell them, and wait for the price to fall before buying back to return, profiting from the price difference.

Method 2: Futures Trading — Pay margin to short, but need to roll over before expiry, facing rollover risk.

Method 3: CFD Contracts — Also based on margin, no need to roll over but must be cautious of margin calls. Regardless of the method, if prices rise beyond expectations, forced liquidation due to insufficient margin can occur.

Why Do Short Squeezes Occur Frequently

Short squeezes are usually triggered by two main reasons.

Capital manipulation-induced short squeeze events

The 2021 GME incident is one of the most classic recent cases. This game retailer had been losing money for years due to declining console gaming, with its stock price hitting rock bottom. In September 2020, Canadian businessman Ryan Cohen heavily invested and joined the board, bringing hope for reform. The stock rebounded from single digits to around $20.

Wall Street institutions then issued bearish reports, claiming the valuation was too high, and started shorting. Because GME had a limited float, short sellers borrowed shares equivalent to 140% of the company’s total shares—this number itself planted the seed of crisis.

Reddit’s community forum WSB noticed this and decided to buy GME to squeeze the shorts. The situation escalated rapidly in January 2021: on January 13, the stock surged 50% to $30, and within two weeks (January 28), it skyrocketed to $483, eventually breaking above $600 during the short squeeze. Short sellers, exhausted on margin, were forced to cover, resulting in market losses exceeding $5 billion.

After the short squeeze, the stock price plummeted quickly, dropping over 80% by early February. Subsequently, the WSB team also attempted to hype stocks like AMC and BlackBerry with high short interest, but they all experienced brief surges followed by rapid declines.

Fundamental improvement leading to natural short squeeze

Another type of short squeeze stems from genuine performance changes. Tesla is a typical example.

Tesla grew through hardships; despite continuous losses for years, its electric vehicles were seen as the future trend. Coupled with large market capitalization and high liquidity, it became the stock with the highest short interest. Until 2020, the company turned profitable, and its Shanghai Gigafactory experienced explosive growth, changing the situation entirely. In just half a year, the stock price soared from 350 yuan to 2,318 yuan, nearly a 6-fold increase. After a stock split adjustment, the price remained above 1,000 yuan within a year, with a total increase of nearly 20 times over two years.

This fundamental-driven rise causes huge losses for short sellers, but unlike manipulation, it often reflects a genuine revaluation of the company’s value.

How to Self-Rescue When Facing a Short Squeeze

Short selling is a high-risk operation. Whether profitable or not, safe exit is the top priority. The maximum profit from shorting is when the stock price drops to zero, but predicting the ceiling is impossible, making it an investment with “limited gains and unlimited risks.”

When facing a short squeeze threat, two practical strategies are recommended:

Strategy 1: Defend High Short Positions

When short interest exceeds 50% of circulating shares, even if the stock remains weak, it is advisable to close positions early. Small gains or losses are acceptable; survival is the priority.

This can be aided by observing the RSI indicator. RSI between 50-80 indicates a clear bullish advantage; 20-50 indicates bearish dominance; but the most dangerous signal is RSI dropping below 20—this suggests the market is in an oversold zone, and the reversal probability increases significantly. At this point, decisive exit is necessary to avoid falling into a short squeeze vortex.

Strategy 2: Set Take-Profit Points When Participating in a Short Squeeze

If you want to actively participate in a short squeeze to force a rally, you must continuously monitor short interest. As long as short interest keeps increasing, there is room for a short squeeze. However, once signs of short covering appear, you should immediately take profits and exit.

Because these buying actions are not based on genuine optimism about the company’s prospects but are merely to ride the wave of inflated prices, once the short squeeze ends, the stock price will quickly revert to its reasonable valuation. The price swings are often extreme, so avoid being stubborn.

How to Avoid Short Squeeze Risks and Short Safely

A short squeeze requires two preconditions: excessive concentration of short interest and extremely high market attention.

Investors should prioritize shorting large-cap indices or blue-chip stocks, as assets with high liquidity are less likely to accumulate dangerously high short interest concentrations.

In a bear market, it is advisable to wait for rebound opportunities before shorting, rather than blindly being bearish all the time. Borrowing stocks to short carries the risk of broker forced buy-ins; CFD contracts are more suitable for controlling leverage.

An advanced strategy is to hedge: simultaneously buying stocks for long positions and shorting the index. With a 1:1 allocation ratio, profits can be made as long as the individual stocks outperform the index or decline less.

In summary, short squeezes are a systemic risk for short investors. Besides monitoring market chips and technical indicators, paying close attention to fundamentals and news is crucial—an optimistic news event can wipe out years of shorting efforts. Caution and discipline are the true shields in short trading.