Why are investors most afraid of short squeezes? An article explaining the risks of short squeezing and how to respond

1. What is a Short Squeeze, and Why Does It Terrify Short Sellers?

In financial markets, there is a situation that can cause short investors to suffer huge losses in an instant, known as Short Squeeze, commonly called “尬空” (Gà Kōng).

Simply put, a short squeeze occurs when the price of a stock or asset being shorted rises sharply, forcing short investors to buy back shares at high prices to cover their positions, which further drives up the asset’s price. This creates a vicious cycle: short covering → buying pressure → stock price continues to soar → more short positions are forced to cut losses.

The dilemma faced by short investors is the essence of a short squeeze — their profit potential is limited to the stock price dropping to zero, but their losses are unlimited. The stock price can increase tenfold, a hundredfold, and your losses will grow infinitely. That’s why the market often says: Long positions earn slowly but steadily, while short positions come quickly but carry boundless risks.

2. Three Ways to Short and Their Respective Risks

How can investors short without owning the underlying shares? Mainly through three methods:

1. Borrow and Sell Shares Directly
Borrow shares from long-term shareholders, pay interest, then sell. When the price drops, buy back shares to return to the lender. The advantage is simplicity, but if the stock price surges, you may face forced buy-in.

2. Futures Contracts
Deposit margin and short futures contracts, which require rollover at expiration. If the stock price rises rapidly, your margin might be insufficient, leading to margin calls or forced liquidation by the broker.

3. CFD (Contract for Difference)
Use margin trading with adjustable leverage, no need to rollover. However, the principle is similar; if the stock price rises too much, you risk forced liquidation.

Regardless of the method, once a large number of short positions are willing to take the other side, speculative capital can trigger a short squeeze. Because to push the stock price higher, you need someone to buy in.

3. Why Do Short Squeezes Occur? Two Main Trigger Mechanisms

Events manipulated by specific forces

The GME short squeeze is one of the most classic recent examples.

GME is a video game retailer, suffering annual losses as the gaming industry shifts toward mobile and PC. In 2020, Canadian entrepreneur Ryan Cohen heavily bought shares and joined the board, aiming to turn the company around. This news drove the stock from single digits to nearly $20.

Wall Street institutions quickly issued reports claiming GME was severely overvalued and recommended shorting. Due to GME’s small market cap and poor liquidity, institutions began borrowing shares to short, with short interest even exceeding 140% of the circulating shares.

This caused a frenzy on the Reddit forum WSB. Many users called for collective buying to fight Wall Street. As a result, in just two weeks in January 2021, the stock price skyrocketed from $30 to $483.

Short sellers faced margin calls and were forced to cover, reportedly losing over $5 billion. A week later, the price plummeted over 80%. Subsequently, WSB users also hyped other high short-interest stocks like AMC and BlackBerry, with similar trajectories.

Natural rise driven by fundamentals

Tesla is a typical example.

Tesla has been unprofitable for a long time, but as the leader in electric vehicles, investors remain optimistic. In 2020, the company turned profitable, with revenue from Shanghai factory exploding, and the stock price nearly sixfold in six months (from 350 to 2318). Later, a 1-for-5 stock split was conducted. Within a year, the stock rose from over 400 to over 1,000, with a total increase of nearly 20 times in two years.

While such rises are driven by fundamentals, they also cause huge losses for short sellers. Plus, the global QE stimulus in 2020 made this surge especially fierce.

4. How Should Investors Respond to a Short Squeeze?

Strategy 1: Monitor Short Interest Ratios and Exit Timely

If short interest exceeds 50% of the circulating shares, even if the stock price is still falling, it’s advisable to cover early. Small gains or losses are less important; protecting your capital is paramount.

Observe the RSI indicator as a reference:

• RSI between 50~80: Bullish momentum stronger than bearish, market suitable for long positions
• RSI between 20~50: Bearish momentum stronger than bullish, market suitable for shorting
• RSI below 20: Oversold condition, market is irrational, high chance of reversal

When RSI drops below 20, to avoid getting caught in a short squeeze, it’s best to exit promptly. Holding on blindly will only amplify losses.

Strategy 2: If Participating in a Short Squeeze, Control Risks Strictly

If you want to follow the trend and participate in a short squeeze, closely monitor short interest changes. As long as short interest continues to increase, the squeeze can persist; once signs of short covering appear, take profits immediately.

Because such buying is purely to cover positions, not based on confidence in the company’s fundamentals. When the short squeeze ends, the stock price will quickly revert to a reasonable level, with very volatile swings.

5. How to Avoid Becoming a Victim of a Short Squeeze?

A short squeeze generally requires two preconditions: excessively high short interest and extremely high market attention. To mitigate risks, investors can do the following:

Choose Large Assets
Prioritize major indices or blue-chip stocks. These assets have huge liquidity, making it difficult to form high short interest, thus reducing the risk of a short squeeze.

Wait for Rebound Opportunities
In a bearish market, avoid rushing to short. Wait until the market rebounds before entering, which makes risk more manageable.

Avoid Borrowing Shares to Short
Not recommended due to the risk of forced buy-in. CFD contracts are relatively safer, allowing investors to control leverage and avoid rollover issues.

Hedging Strategies
One approach is to buy stocks long while shorting the major index. If the allocation ratio is 1:1, as long as the stock outperforms the index in gains or underperforms in declines, profits can be achieved. This way, you participate in upward trends while hedging systemic risks.

6. Advice for Short Sellers

Short squeezes are often disastrous for short sellers. When the market falls into a short squeeze cycle, fundamental and technical analyses may become ineffective. A single positive news can trigger a chain of short covering, leading to total losses.

The key is: short selling is like robbing a bank — it doesn’t matter if you get the money, the priority is to escape safely. Preserving your capital is always more important than chasing the last bit of profit. Pay attention to order flow, stock fundamentals, and news developments, set stop-loss points, and this is the secret to surviving long-term in the market.