How to avoid short-selling risks? Essential short-selling strategies every short investor should know

Short Squeeze can be said to be the nightmare of all short investors. Many people only know that shorting can earn quick profits, but overlook the huge risks hidden within — once caught in a short squeeze, not only are profits wiped out, but they may also face unbearable losses.

What exactly is a short squeeze? Why should investors pay attention?

A short squeeze, also known as “嘎空,” simply means forcing short investors to cover their positions. When the stock price of a shorted stock rises rapidly, short sellers may be forced to buy back shares at high prices due to margin calls or forced liquidation, and this action further drives up the stock price, creating a vicious cycle.

There are two common types of short squeeze: one is when the stock price rebounds too quickly, causing short sellers to panic; the other is when influential market funds intentionally manipulate the stock to rapidly push up the price for profit.

Three common ways to short sell

Investors who want to short a target mainly have the following methods:

Borrow stocks to sell — Borrow stocks from long-term shareholders and pay interest, then sell and wait for the price to drop before buying back. The risk with this method is that if the stock price continues to rise, it’s very likely to be forcibly covered by the broker.

Futures trading — Short sell after paying margin, but requires periodic rollover. When the stock price surges, there is also the risk of margin calls or even liquidation.

CFD contracts — No need to rollover, and leverage can be adjusted freely. However, if the stock price keeps rising during a short, insufficient margin can trigger forced liquidation.

Why does a short squeeze occur? Real case analysis

2021 GME incident: Retail investors unite to target Wall Street

GME is a game console retailer that has been losing money for years due to industry decline. In September 2020, Canadian entrepreneur Ryan Cohen made a large purchase and joined the board, causing the stock price to rise from single digits to nearly 20 dollars.

Wall Street institutions immediately issued reports claiming GME was severely overvalued and began large-scale shorting. Surprisingly, the short interest exceeded 140% of GME’s total shares — every short seller was convinced this company would eventually fall back to its intrinsic value.

But this news exploded on Reddit’s WSB forum. Stock enthusiasts rallied online to buy GME collectively to trigger a short squeeze on Wall Street. On January 28, 2021, the stock price skyrocketed from 30 to 483 dollars. Short positions, facing margin calls, were forced to cover, with reports indicating short sellers lost over 5 billion USD.

The short squeeze wave continued to spread, and similar high short-interest stocks like AMC, BlackBerry, and others experienced short-term skyrocketing followed by rapid declines.

Tesla’s fundamental change

Unlike GME’s man-made manipulation, Tesla’s stock price increase was driven by fundamental improvements. The company had been losing money for years, with heavy short positions. But in 2020, it turned profitable, with the Shanghai Gigafactory experiencing explosive growth, and the stock price surged nearly 6 times within half a year (from 350 to 2318). Later, a 1-for-5 stock split was implemented, and within a year, the price broke 1,000 from over 400. In just two years, the stock price increased over 20 times, causing significant losses for short sellers.

Practical strategies for dealing with a short squeeze

First tip: Monitor short positions and technical indicators

When short interest exceeds 50% of the circulating shares, even if the stock price is still declining, consider early covering to hedge risk. At this point, observe the RSI indicator:

• RSI between 50 and 80 → Bullish momentum is strong, suitable for long positions
• RSI between 20 and 50 → Bearish momentum is stronger, still suitable for shorting
• RSI below 20 → Over-sold condition, high risk of reversal, consider exiting promptly

Second tip: If participating in a short squeeze

If you want to follow the short squeeze trend, closely monitor short covering movements. As long as short positions continue to increase, you can participate; once short covering begins, exit to lock in profits immediately. This buying wave is driven by covering rather than fundamental optimism, so price swings can be extremely volatile. After the short squeeze ends, the stock price will quickly fall back to reasonable levels.

How to select targets and safely short

A short squeeze usually requires two preconditions: excessively high short interest and intense market attention. To avoid this risk, investors should prioritize large-cap indices or blue-chip stocks, as their high liquidity makes extreme short concentration unlikely.

In a bear market, it’s advisable to wait for a market rebound before shorting, rather than rushing in at the bottom. Compared to borrowing stocks for shorting, which can be forcibly covered, using CFD contracts offers more controllable risk because leverage can be adjusted at will.

An advanced hedging strategy is: buy individual stocks long while shorting the broader market, maintaining a 1:1 ratio. As long as the stock outperforms the market in gains or underperforms in declines, investors can profit.

Final reminder

A short squeeze can be catastrophic for short investors. Besides closely monitoring order book movements and short data, it’s crucial to pay attention to changes in stock fundamentals and news. Often, a single positive news can destroy years of effort. Investors must stay vigilant and find a proper balance between gains and risks.