Full Analysis of Short Squeeze Risks: From Wall Street Disasters to Practical Response Guides

In volatile financial markets, short sellers often face a unique and dangerous dilemma—when they bet on a stock to decline, the market suddenly reverses. This phenomenon is known as a short squeeze. For many investors, a short squeeze represents a moment of shattered dreams and is one of the most unpredictable risks in short selling. This article will explore the mechanics of short squeezes, historical cases, and how investors can respond to this challenge.

The Essence of a Short Squeeze: Why Do Shorts Get Forced to Cover?

A short squeeze occurs when the price of a stock or asset that has been heavily shorted rises sharply, forcing short investors to buy back the assets at higher prices to cover their positions. Simply put, a short squeeze is the market forcing short sellers to cut losses.

To understand how a short squeeze happens, first, it’s important to know the three basic ways to short a stock. The first is “borrowing stocks to sell,” where investors borrow shares from long-term shareholders, pay interest, and sell them, hoping to buy back at a lower price later. The second involves “futures” contracts, where investors pay margin to short, but need to roll over positions at expiry. The third uses “CFD contracts,” which also require margin but do not involve physical ownership or transfer.

Regardless of the method, short investors face the same core risk: as the stock price rises, their margin gets eroded. If the price surges rapidly, their margin can be depleted quickly, leading to forced liquidation by the broker. This forced liquidation further drives up the stock price, creating a vicious cycle—shorts are forced to cover at higher prices, which pushes the price even higher, triggering more forced covers.

Two Real Cases of Short Squeezes

Tesla: Fundamental Shift Triggers a Short Squeeze

Before 2020, Tesla was seen as the future of electric vehicles, but the company was consistently unprofitable, with sales struggling to grow. As a result, it became a target for institutional short selling, with the short interest reaching some of the highest levels in the market.

A turning point came in 2020. Tesla turned profitable, and its Shanghai Gigafactory began significantly contributing to revenue. This fundamental improvement sparked a surge in market buying. Within six months, Tesla’s stock skyrocketed from $350 to $2,318, nearly a sixfold increase. Later, the company conducted a 1-for-5 stock split, and within a year, the price rose from over $400 to over $1,200 (peaking at $1,243). In just two years, the stock price increased nearly 20 times.

This short squeeze caused heavy losses for short investors. Unlike GME, Tesla’s squeeze was driven by real fundamental changes, not manipulation, though subsequent global QE liquidity injections undoubtedly amplified the rally.

GME vs. Wall Street: Man-Made Manipulation Causes a Short Squeeze

In January 2021, an event on the Reddit forum WallStreetBets (WSB) shocked global markets—the famous GME short squeeze.

GME (GameStop) is a video game retailer, whose performance had been declining due to shifts toward mobile and PC gaming. After the pandemic outbreak in 2020, its stock price kept falling, and many Wall Street institutions believed it was severely overvalued, initiating large-scale short positions.

The turning point came with Canadian entrepreneur Ryan Cohen, who in September 2020 bought a large stake in GME and joined its board, announcing plans to transform the company. This news drove the stock from single digits to nearly $20. However, the short selling pressure intensified—short interest reached 140% of GME’s total shares outstanding, far exceeding the free float.

This news ignited a wave of outrage on WSB. Retail traders, angry at Wall Street’s manipulation, united to buy GME shares, forcing the shorts to cover. In just two weeks, buying pressure exploded: on January 13, 2021, the stock surged 50% to $30, and by January 28, it hit a peak of $483.

As the stock soared, short sellers’ margins were rapidly eroded. To avoid further losses, they were forced to buy back shares at high prices, pushing the price even higher. Media reports indicated that losses for short sellers exceeded $5 billion. Within a week, the stock plummeted over 80% from its peak by February 2.

Subsequently, WSB traders expanded their short squeeze tactics to other heavily shorted stocks like AMC and BlackBerry, which also experienced rapid surges followed by sharp declines.

Conditions for a Short Squeeze

Short squeezes do not happen randomly; they typically require several preconditions:

First, the short interest must be excessively high. When short interest exceeds 50% of the float, the risk of a squeeze increases significantly because a large short position implies substantial potential buyback demand.

Second, market attention must be intense. When a heavily shorted stock attracts widespread interest, it can trigger coordinated buying among traders. The GME case is a prime example—broad attention from both institutions and retail investors fueled the extreme short squeeze.

Third, there must be a trigger—either a sudden fundamental improvement (like Tesla’s profit turnaround), man-made manipulation (like WSB’s coordinated action), or a sudden shift in market sentiment.

Practical Strategies for Responding to a Short Squeeze

For investors with existing short positions, a short squeeze can be a nightmare. Knowing how to protect profits during a squeeze is crucial.

Strategy 1: Recognize Early and Cut Losses

If short interest exceeds 50% of the float, even if the stock price remains weak, consider closing the position early. Monitor indicators such as order flow and RSI (Relative Strength Index). RSI measures momentum:

• RSI between 50–80 suggests bullish strength
• RSI between 20–50 indicates bearish strength
• RSI below 20 signals oversold conditions, with a high likelihood of reversal

The key for short sellers is to be alert when RSI drops below 20, as this indicates oversold conditions and potential for a reversal. At this point, a short squeeze could erupt at any moment. The safest approach is to exit promptly, accepting small gains or losses—preserving capital is paramount.

Strategy 2: If Participating in a Short Squeeze

If an investor chooses to actively participate in a short squeeze, they must closely monitor short interest levels. As long as short interest continues to rise without signs of covering, it may be advantageous to keep pushing the squeeze. However, once signs of short covering appear, it’s prudent to take profits and exit.

Note that buying during a squeeze is often driven by technical momentum rather than fundamentals. The rally can be volatile, and once the stock reverts to a reasonable valuation, it tends to fall sharply.

How to Prevent Short Squeeze Risks and Achieve Steady Short Selling

For those who want to short but avoid the risks of a squeeze, here are some key precautions:

Choose the Right Targets

Major indices or large-cap stocks are safer options for shorting because their high liquidity prevents extreme short interest levels. Small-cap stocks or highly followed individual stocks are more susceptible to short squeezes.

Timing the Entry

In a bear market, the best time to short is during market rebounds when fundamentals remain weak. Shorting during a rally in a weak economy can be advantageous.

Select Appropriate Instruments

Borrowing stocks to short is generally not recommended due to the risk of forced buy-ins by brokers. CFD (Contract for Difference) trading is often more suitable, as it uses margin but allows better risk control and leverage management.

Use Hedging Strategies

Investors can hedge their positions by simultaneously going long on selected stocks and shorting indices. For example, if the long position in stocks is equal to the short position in the index, gains in one can offset losses in the other, reducing overall risk.

Conclusion

Short squeezes are among the most unpredictable risks for short sellers. Whether driven by sudden fundamental changes or coordinated manipulation, they can lead to catastrophic losses. Short selling is akin to undertaking a risky mission—regardless of potential gains, safety and timely exit are the top priorities.

Investors should pay close attention to market signals, monitor stock fundamentals and news, and employ scientific risk management, position sizing, and appropriate tools. Only through disciplined strategies can they navigate complex markets, avoid pitfalls, and achieve steady profits from short selling.