Short selling meaning analysis: How can investors identify and respond to this risk trap?

What is a Short Squeeze? The Nightmare of Forced Liquidation

A short squeeze (Short Squeeze), also known as “嘎空,” is the scenario that short investors fear the most. Simply put, it occurs when the price of a shorted asset rapidly rises, forcing short sellers to cover at high prices, creating a vicious cycle that drives the price even higher.

There are two types of short squeezes. One is when the stock price rebounds too quickly, and short sellers are forced to cut losses and cover due to unbearable losses; the other involves groups with manipulation ability deliberately pushing up the stock price to trap retail and institutional short positions for profit.

To understand the power of a short squeeze, first understand the three ways to short:

Borrow stocks to sell — Borrow stocks from long-term shareholders, pay interest, and buy back after the price drops.

Futures trading — Pay margin to short, and upon expiry, need to rollover. There is a risk of forced liquidation if the stock price rises continuously, causing margin calls.

CFD contracts — No rollover needed but also subject to margin call risks.

All these methods share a common weakness: when the stock price surges strongly, investors may face the despair of margin calls and forced liquidation by brokers.

Why Do Short Squeezes Occur? The Dual Forces of Institutional Sniping and Fundamental Reversal

Short squeezes are not accidental; there are two main drivers behind them.

First type: Deliberate manipulation of short squeeze events

The GME short squeeze in 2021 is a textbook case. GME is a game console retailer with declining performance, widely viewed as overvalued by Wall Street. After Canadian entrepreneur Ryan Cohen took a seat on the board, the stock price soared from single digits to nearly $20. Wall Street immediately issued short reports, claiming the stock was severely overvalued.

The problem was, GME had a small market cap and low trading volume. Short institutions borrowed a large amount of stock to short, with short positions reaching up to 140% of the float. This became a “prey” in the eyes of Reddit’s WSB investors. They called for collective buying to force Wall Street to admit defeat.

The results were shocking: on January 13, 2021, the stock surged 50% to $30, and within two weeks, it peaked at $483. Short positions were forced to cover due to margin shortages, with media reporting losses exceeding $5 billion. A week later, the stock plummeted over 80%. Subsequently, WSB members also hyped other high short-interest stocks like AMC and Blackberry, which experienced short-term surges followed by sharp declines.

Second type: Natural buying driven by fundamental improvement

Tesla is another classic example. Long targeted by shorts, Tesla turned profitable in 2020. The Shanghai Gigafactory’s revenue exploded, and the stock price nearly sixfold in half a year, from $350 to $2,318. After a stock split, the price again surpassed $1,000 within a year (peak at $1,243). In just two years, the stock price increased nearly 20 times, causing heavy losses for short sellers.

This type of short squeeze stems from genuine fundamental changes, combined with the global QE easing environment in 2020, which continuously fueled buying.

Both types of short squeezes cause huge losses for short sellers, especially in 2022 when the market shifted from bullish to tightening with Fed rate hikes and balance sheet reduction. Every rebound became a new trap for shorts.

Self-Help Guide When Facing a Short Squeeze

Short selling is like robbing a bank—“safe withdrawal” is the top priority. The maximum profit from shorting is when the stock price drops to zero, but once caught in a short squeeze, the price can skyrocket multiple times or even dozens of times in a short period, turning shorting into a “limited profit, unlimited risk” strategy.

First strategy: Monitor short interest and admit early losses

If short interest exceeds 50% of the float, even if the stock remains weak, it’s advisable to cut losses early. Use RSI as an early warning indicator:

• RSI between 50~80 = Bullish market, prone to squeeze
• RSI between 20~50 = Bears have slight control, still suitable for shorting
• RSI below 20 = Oversold, high risk of reversal, must exit immediately

When RSI drops below 20, the market is irrational, and a squeeze can erupt at any time. Protecting capital is more important than chasing profits.

Second strategy: If participating in a squeeze, strictly control exit timing

Investors aiming to profit from a squeeze must continuously monitor short positions. As long as short interest keeps increasing, the squeeze can continue. But once signs of short covering appear, exit immediately.

Because the buying pushing up the stock price is not based on company fundamentals but to cover short positions. Once the squeeze ends, the stock price will quickly fall back to a reasonable level, with very volatile swings.

How to Avoid Short Squeeze Traps and Safely Short

A short squeeze typically requires two conditions: excessively high short interest + extremely high market attention.

When choosing stocks to short, investors should prioritize major indices or blue-chip stocks, which have high liquidity and are less likely to have concentrated short positions.

In a bearish market, it’s better to wait for a rebound before shorting, rather than blindly shorting at highs. Pure borrowing to short is not recommended due to the risk of forced buy-ins. Using CFDs offers more flexibility, allowing investors to control leverage ratios.

An advanced approach is hedging: buy stocks long while shorting the market. With a 1:1 ratio, as long as the stock outperforms the market or underperforms less, investors can profit and effectively hedge systemic risks.

Investors should closely monitor order flow and also keep an eye on fundamental and news developments. Any positive news can destroy long-term short positions, and the risk of a squeeze is no joke. Understanding what a short squeeze means and mastering the response methods is the first lesson in shorting investment.