Understanding a short squeeze: an introduction for Swiss investors

Ever since the spectacular GameStop hype of 2021, the term "short squeeze" has been widely discussed. Even in Switzerland, many people followed with fascination as retail investors unexpectedly put large hedge funds under pressure. But what exactly is behind this phenomenon, and why does it often resemble gambling more than solid investing?

In this article, you'll gain a clear and well-founded understanding of how a short squeeze works, learn about famous cases like GameStop and Volkswagen, and get practical tips on how to assess and minimise risks.

What is a short squeeze?

To understand a short squeeze, you first need to know what short selling means. This is when investors sell borrowed shares, expecting their price to fall. If the price drops as expected, they buy the shares back at a lower price and return them to the lender—pocketing the difference as profit. However, if the price rises instead, short sellers face losses because they have to buy back the shares at a higher price.

A short squeeze occurs when the opposite of expectations happens: the stock price rises sharply instead of falling. Short sellers come under pressure to quickly close their positions to limit their losses. This, in turn, increases demand for the stock, pushing the price even higher—a chain reaction begins. More and more short sellers are "squeezed out" as the pressure mounts to contain losses. This dynamic can lead to a dramatic price surge.

Simply put, a short squeeze is a rapid price increase triggered when numerous short sellers are forced to buy back shares at the same time.

Think of it like sports betting: many people bet on a team losing. But then, unexpectedly, the team starts dominating the game. In response, all the bettors try to withdraw their bets at once, causing the odds to rise rapidly. Similarly, a short squeeze unfolds on the stock market as an upward spiral, driving prices higher and higher.

In Switzerland, short selling is generally allowed as long as it is covered. However, "naked shorts"—selling shares without first borrowing them—are prohibited. Short sellers must be able to prove that they either hold the shares or have borrowed them.

Famous short squeezes: case studies of GameStop and Volkswagen

Short squeezes have occurred throughout history, but two cases stand out as particularly instructive for investors.

1. The GameStop short squeeze

The GameStop short squeeze of early 2021 became a global David-versus-Goliath story. Hedge funds had bet that the stock price of the US video game retailer GameStop would continue to fall—more than 100% of the freely tradable shares had been shorted. Meanwhile, a group of retail investors on an online forum (Reddit) aimed to drive the price up. Through coordinated purchases, they managed to push the stock price up dramatically in just a few weeks.

On 27 January 2021, GameStop's share price temporarily soared to $347.51—about 30 times its value at the start of the month. Hedge funds, particularly Melvin Capital, suffered massive billion-dollar losses as they were forced to close their short positions.

However, the downside of the short squeeze effect soon became evident. Once most short sellers had been "squeezed out," the stock price quickly dropped again. Just a week after its peak, GameStop was trading at around $53. Many latecomers who got caught up in the hype ended up facing significant losses. This example illustrates how quickly a short squeeze can unfold—and how fast it can disappear.

2. The Volkswagen short squeeze

Another legendary short squeeze took place in October 2008 in Germany. Hedge funds had heavily bet against Volkswagen (VW), expecting the automaker to struggle during the financial crisis. Around 12.5% of all VW shares had been shorted—an extremely high short position.

At the same time, Porsche, a competitor and VW shareholder, quietly increased its stake to around 74% through options. When this became public, short sellers panicked: hardly any freely tradable shares were available for them to buy back. Within just five trading days, VW's share price skyrocketed to nearly €1,000—about five times its previous value. For a brief moment, Volkswagen became the most valuable company in the world.

This case shows how unexpected market developments (in this case, Porsche's takeover plans) can put short sellers in a dangerous position. Those who exited too late paid a heavy price. After most short sellers capitulated, VW's share price eventually normalised. But the episode went down in stock market history as a cautionary tale, with some hedge funds suffering billion-dollar losses while Porsche emerged as the winner.

How to spot a short squeeze: indicators and warning signs

Short squeezes often hit the market unexpectedly. However, there are several clear warning signs that investors should watch for. None of these indicators guarantee a short squeeze, but if multiple factors occur together, the risk increases significantly. In such cases, be especially cautious, as these situations are highly speculative and risky.

• High short interest: When many investors bet against a stock, the risk of a short squeeze rises. A short interest of over 10–20% of the freely tradable shares is already a warning sign. This data is available from financial service providers or stock market platforms.

• Days to cover: This metric indicates how many days it would take for all short sellers to buy back their shares. A high value means it could be difficult to find enough shares quickly in an emergency, increasing the risk of a squeeze.

• Small companies with low trading volume: Stocks of smaller companies often need only a few buy orders to rise sharply, especially if major investors already hold most shares. Such stocks are more vulnerable to short squeezes.

• Sudden price movements and technical signals: If a heavily shorted stock starts rising suddenly or is in an oversold range (e.g. an RSI below 30), it could signal a potential short squeeze.

• Positive news or social media hype: Unexpected good news or increasing attention on social media (as seen with GameStop on Reddit) can quickly attract many buyers and force short sellers to close their positions.

Strategies to minimise risk in short squeezes: what investors should watch out for

Given the risks mentioned above, what can you do as an investor to minimise them? Here are some key strategies and tips:

1. A clear investment strategy and diversification: Do not let market hypes distract you from your long-term strategy. Build a well-diversified portfolio. A strong mix of assets—such as stocks, ETFs, and alternative investments—helps reduce concentration risk. Focus on companies with solid fundamentals and approach short-term trends with healthy scepticism.

2. Caution with hype stocks and meme stocks: Think twice before jumping on the bandwagon. If a stock is rising purely because of a Reddit trend or TikTok hype, that should raise red flags. Ask yourself: is the surge driven by company performance or mere speculation? If it is the latter, you may be treading on thin ice.

3. Staying informed and monitoring the market: Keep yourself updated on short interest data and market news. Many financial platforms publish current short-selling ratios for stocks. If you notice that a stock you hold has extremely high short interest, be prepared for increased volatility. Also, keep an eye on corporate announcements—news of acquisitions, share buybacks, or new major investors can put short sellers under pressure. Closely monitoring your investment portfolio and its holdings will help you react promptly to unusual price movements.

4. Seeking professional advice: If all of this seems too complex or risky, financial experts are available to help. In volatile markets or when tempted by ‘hot stocks’, a neutral perspective can be invaluable. An experienced financial adviser can assess whether a situation is fundamentally justified or if you are at risk of falling for market exaggerations. Do not hesitate to seek professional advice before making large investments or taking on risky positions. An independent expert view can help you avoid costly mistakes.

Conclusion: short squeezes should be approached with caution

Short squeezes are spectacular but highly risky market events. For Swiss investors, they serve as a reminder that stock prices are driven not only by fundamental data but also by market psychology.

For most private investors, the key is to stay calm. Do not be dazzled by quick profits; instead, focus on building your wealth with well-thought-out, diversified investments.

Finally, if you are unsure how to invest in turbulent times or have general questions about your investment strategy, our advisory team is here to help. Contact us for a no-obligation consultation—we will work with you to develop an investment strategy tailored to your needs, ensuring peace of mind even in volatile markets.