Short Selling Deep Dive: A Nightmare for Bears Based on Wall Street Lessons

Short selling sounds simple—identify overvalued stocks to sell, then buy back after they fall to profit from the difference. But this process hides a hidden risk trap: Short Squeeze, also called Gagging.

What is a Short Squeeze? Simply put, it’s being countered

The essence of a short squeeze is straightforward—when short positions are too large, once the stock price rises, short sellers are forced to cover at higher prices, which further drives up the stock price, creating a vicious cycle.

Here’s an example to understand the meaning of a short squeeze: Suppose you believe a stock is seriously overvalued, and you borrow 100 shares to sell at 50 yuan. As buyers flood in, the stock price rises to 60 yuan. To cut losses, you buy back, which pushes the price up to 65 yuan. Other short sellers see the price rising and rush to cover, causing the stock to soar to 100 yuan. In the end, the entire short position suffers heavy losses.

There are two types of short squeezes:

Passive Short Squeeze — The stock price rebounds too quickly, forcing short sellers to buy back at high prices

Active Short Squeeze — Capital groups deliberately inflate the stock price, teaming up to force short sellers out, and then enjoy huge profits

Why does a short squeeze occur? Dense short positions are the trigger

Situation 1: Intentional manipulation by speculative funds

The most famous case is the GME event. In 2020, the struggling game console company GME was heavily shorted on Wall Street, with a short ratio reaching 140% (more shorts than total shares).

But after Ryan Cohen acquired and reorganized the company, retail investors on the US forum WSB launched a counterattack—“Let’s buy together and push Wall Street out.” In January 2021, the stock soared from 30 yuan to 483 yuan, causing over $5 billion in losses for short sellers. This is a classic short squeeze event.

Situation 2: Natural buying driven by improved fundamentals

Tesla is another example. After Tesla, which had been losing money for a long time, turned profitable in 2020, its stock price surged sixfold in just half a year. Later, after a stock split, the price increased tenfold within a year. The short positions suffered heavy losses during this rally.

This was not manipulation but genuine fundamental improvement, with buying naturally pouring in, causing short sellers to be passive.

How should short sellers face the risk of a short squeeze?

Strategy 1: Exit early when short positions are extremely large

When short positions exceed 50% of the circulating shares, even if the price is still falling, consider partially or fully covering. The reason is simple—any positive news or surge in buying can trigger a short squeeze instantly.

Technical indicators can help judge:

• RSI below 20 indicates the market is oversold, with a high risk of reversal; short sellers should stop loss immediately
• RSI between 20-50 is relatively safe for shorting
• RSI between 50-80 indicates strong bullish momentum, highest risk

Strategy 2: If you want to ride the short squeeze wave, monitor short position changes closely

If short positions keep increasing, you can follow with long positions to accelerate the squeeze. But once you see short covering begin, exit early to lock in profits. Because after the squeeze ends, the stock price will quickly fall back to a reasonable level, and it will be too late to escape.

How to avoid becoming a victim of a short squeeze?

Prioritize large-cap indices or blue-chip stocks—these assets have huge liquidity and are less likely to have excessively concentrated short positions. GME and Tesla became major short squeeze targets mainly because of their small market cap and weak liquidity.

Enter short positions only after rebounds—in a bear market, wait for signs of a rebound before establishing short positions, rather than chasing every decline.

Control leverage risk—regardless of the shorting tools used, set reasonable stop-loss points. The maximum profit from shorting is zeroing out the stock, but the risk is unlimited. This asymmetry makes risk management crucial.

Diversify investments to reduce risk—consider long positions in quality stocks and hedge with short positions on the market index. As long as the stock’s gains outpace the index or its declines are smaller, you can achieve stable profits.

In essence, a short squeeze is a game of market participants. Understanding what a short squeeze means and mastering its规律 (rules) will help you go further in short selling. Remember: Safe retreat is always the top priority. Small losses and small gains are nothing compared to the huge losses caused by being caught in a short squeeze.