Short squeeze market analysis: From short squeeze concept to practical defense

Global financial markets are experiencing increasing volatility, and investment strategies are becoming more diverse. In addition to traditional buy-and-hold, more and more investors are venturing into short-selling. However, as the saying goes: going long yields steady but slow gains, while shorting offers quick profits but risks hidden in the details. Among the many pitfalls of short-selling, short squeeze is undoubtedly one of the most intimidating.

What is a Short Squeeze? The Logic Behind Forced Liquidation

Short squeeze, also known as “嘎空,” refers to the phenomenon where short investors are forced to buy back their short positions. Simply put, when a stock’s price surges rapidly, short sellers face increasing losses and are compelled to cover their positions at higher prices, which in turn drives the stock price even higher, creating a vicious cycle.

Short squeeze events generally fall into two categories: one is a natural rebound where the stock price jumps too quickly, causing short sellers to panic and cut losses; the other is when certain forces deliberately pump up the stock price to trap and target short positions.

Three Ways to Short-Sell

Investors who are bearish on a stock and want to profit from it typically have these three options:

Method 1: Borrow Stocks to Short Borrow stocks from long-term shareholders, pay interest, sell them, and then buy back at lower prices to return to the original owner, earning the difference.

Method 2: Futures Trading Pay margin to short the underlying asset, with the need to roll over before expiry. However, if the stock price skyrockets, margin calls may be triggered.

Method 3: CFD Contracts Short via Contract for Difference (CFD), which also requires margin. The advantage is no need to roll over positions, but rapid price increases can lead to forced liquidation risks.

Regardless of the method used, when stock prices keep rising, the risk of margin insufficiency surfaces. If the rally is fierce, investors may be forcibly liquidated by brokers, which is the most terrifying aspect of a short squeeze.

Why Do Short Squeezes Occur? Market Manipulation and Fundamental Changes

Behind short squeeze events, there are often two main drivers.

Scenario 1: Capital Manipulation Creating a Short Squeeze Drama

GME Incident and Retail Investors’ Counterattack on Wall Street

Back in 2020. GME was a traditional video game retailer, with declining performance due to the rise of mobile gaming, and its stock price fell to single digits. Until Canadian entrepreneur Ryan Cohen took control, the stock rebounded from the bottom to around $20, sparking Wall Street institutional investors’ desire to short.

Key data: GME’s total shares outstanding are not large, with limited liquidity, yet over 140% of shares are shorted—more than the float.

This move caused an uproar on the US Reddit forum WSB. Retail investors united to buy GME to squeeze out Wall Street. As a result, the stock price skyrocketed from $30 to $483 within two weeks, a gain of over 1500%. Short sellers, facing margin calls, were forced to cover heavily, with estimated losses exceeding $5 billion.

Later, the price quickly retreated, dropping over 80% within two weeks. This short squeeze event also triggered a chain of similar actions—high short interest stocks like AMC and Blackberry were also heavily targeted.

Scenario 2: Fundamental Reversal Leading to Natural Price Surge

Tesla’s Shift from Losses to Supply Shortages

Tesla’s story is the opposite. In its early days, the electric vehicle leader suffered long-term losses, and despite some stock price increases, it was widely shorted, making it one of the stocks with the largest short positions.

Until 2020, Tesla turned profitable, with the Shanghai Gigafactory contributing record revenue, and its stock price began to soar. In just half a year, it rose nearly 600%, from 350 yuan to 2318 yuan. After a stock split, the price broke through 1,000 yuan within a year, reaching a high of 1243 yuan. In just two years, the stock price increased nearly 20 times, causing massive losses for short sellers.

This rise was driven by real improvements in the company’s fundamentals, coupled with loose global pandemic policies, rendering short positions powerless.

What to Do When Facing a Short Squeeze? Two Practical Rules

Short selling is like a high-risk battle; safety first is always the priority. Since a short squeeze can push stock prices up several times or even dozens of times in a short period, investors must set up defenses.

Rule 1: Close Positions When Short Ratio Exceeds 50%

When a stock’s short interest exceeds 50% of the float, even if the price appears weak, it’s wise to exit early. Key indicators include:

• RSI between 50 and 80: Market bullishness, suitable for long positions; short sellers should hedge
• RSI below 20: Oversold condition, increasing likelihood of reversal; short squeeze risk is highest

The critical point is when RSI drops below 20, indicating the market is beyond rational limits. To avoid being trapped, exit promptly. Small gains or small losses are acceptable; don’t gamble your entire position.

Rule 2: Take Profits Promptly During a Short Squeeze

If investors want to profit from a short squeeze, they must closely monitor short covering activity:

• Increasing short interest → potential for further short squeeze
• Short covering begins → exit to lock in profits

Because such buying is often driven by forced short covering rather than positive fundamentals, once the short squeeze ends, stock prices tend to fall back rapidly to reasonable levels, with very volatile swings.

How to Profit from Short Selling: Prevention Over Reaction

For a short squeeze to occur, two conditions are usually necessary: excessively high short interest + high market attention.

Stock Selection Strategy: Prioritize Large Caps

Major indices or blue-chip stocks are relatively safer short targets. These assets have high liquidity and are less likely to have concentrated high short interest, reducing the chance of a short squeeze.

Trading Strategy: Wait for Rebound Opportunities

In a bearish market, it’s advisable to short during market rebounds rather than blindly shorting at every high.

Tool Choice: CFD Over Borrowing Stocks

Compared to borrowing stocks, CFDs offer advantages such as more flexible leverage and less risk of forced liquidation. Investors can control leverage ratios and manage risks more effectively.

Portfolio Allocation: Hedging and Risk Balance

A practical approach is to hold both long and short positions simultaneously—buying promising stocks while shorting the market index. With a 1:1 ratio, as long as the stock gains exceed the index or the stock declines less than the index, profits can be realized.

Final Reminder

A short squeeze is a potential disaster for short investors. Besides closely monitoring technical signals, it’s crucial to pay attention to fundamental and news developments. A positive news event can wipe out short sellers’ efforts, while an undervalued short position may hide the seed of the next short squeeze. The wisdom of investing often lies in knowing when to retreat completely.