How Short Selling Works and Why Short Squeezes Happen

TL;DR

• Short selling is selling borrowed shares and later repurchasing the same amount to close the position, realizing profit or loss.
• A short squeeze occurs when short positions face rapid price rises, triggering concentrated buybacks that push prices higher.

Definition and Process of Short Selling

Short selling involves an investor borrowing shares from a broker or asset manager and selling them in the market. At a later date the investor repurchases the same stock and quantity to return the borrowed shares. To realize a profit the repurchase price must be lower than the sale price, and if it is higher a loss occurs. The process involves securities lending, lending agreements, borrowing costs, and collateral requirements. Fees, rules, and availability vary by broker, so confirm current terms with your broker or the relevant authorities.

Why It Matters, Liquidity and Price Discovery

Short selling is considered to correct overvaluation and improve market liquidity. At the same time, excessive short selling can increase selling pressure on a specific stock and trigger sharp short-term declines, drawing regulatory attention. When short positions accumulate, an unexpected positive development or buying surge can cause a rapid rebound and create systemic risk, so monitoring matters.

Common Misconceptions and Reality

• Short selling equals illegal attack? Short selling itself is a legal trading tool. Market manipulation or spreading false information is subject to legal penalties.
• Short selling guarantees profit? Not true. Stock prices can rise without limit, creating potentially unlimited losses.
• Short squeezes are conspiracies by some investors? Usually they occur naturally from position concentration, low liquidity, and abrupt buying pressure.

Numerical Example Using Hypothetical Numbers

Assume Company A stock is 10,000 won and investor B shorts 1,000 shares (borrowed and sold). Cash inflow at sale is 10,000 won×1,000 shares = 10,000,000 won.

Scenario 1, Price Falls (Profit):

• If the price falls to 8,000 won, repurchase cost is 8,000 won×1,000 shares = 8,000,000 won.
• Trade profit is 10,000,000 won - 8,000,000 won = 2,000,000 won (excluding fees and borrowing costs).

Scenario 2, Price Rises (Loss):

• If the price rises to 13,000 won, repurchase cost is 13,000 won×1,000 shares = 13,000,000 won.
• Loss is 13,000,000 won - 10,000,000 won = 3,000,000 won (excluding fees and borrowing costs).

Short Squeeze Example

• If many shorts build up and free float is small, an unexpected positive catalyst can cause shares to surge and short holders to rush to cover.
• Concentrated buy orders in low-liquidity areas push prices up faster and sharply increase covering costs. In the earlier example, if 13,000 won spikes to 20,000 won, repurchase cost becomes 20,000 won×1,000 shares = 20,000,000 won, producing a loss of 10,000,000 won.

Summary and Precautions

Short selling and short squeezes can amplify risk and volatility depending on market structure and position concentration. Fees, lending terms, and regulations change frequently, so verify the latest information before trading.

This article is for informational purposes and is not investment advice.