How the mother of all ‘short squeezes’ helped drive stocks to historic gains Wednesday

The sudden surge in stocks on Wednesday afternoon left many hedge fund short sellers scrambling to cover their positions, leading to a historic rally in the market. Traders who had bet on share price declines by borrowing and selling securities found themselves in a precarious situation as stocks soared following news of a tariff pause by President Donald Trump.

Short selling involves borrowing securities from a bank and selling them with the hope of buying them back at a lower price to make a profit. However, when stocks unexpectedly rise, short sellers are forced to buy back the borrowed securities quickly to limit their losses. This rush to cover short positions created a short squeeze, with the S&P 500 experiencing its third-largest gain since World War II.

Prior to Wednesday’s rally, short positions in the market were at a record high, nearly double the levels seen during the onset of the Covid pandemic in the first quarter of 2020. As hedge funds rushed to cover their short bets, a basket of the most shorted stocks surged by 12.5%, outperforming the S&P 500’s 9.5% gain.

The heavy volume of trading during the session, with a whopping 30 billion shares traded on U.S. exchanges, marked the highest trading volume day on record. This surge in trading activity was fueled by short sellers rushing to cover their positions, creating a frenzy in the market.

While there were also real buyers in the market, long-only funds bought a record amount of tech stocks during the session. However, traders attribute the magnitude of the market move to the shorts running for cover.

The thin liquidity in the market also contributed to the extreme price swings seen on Wednesday. Markets were pulling back on Thursday as investors realized the ongoing risks posed by high China tariffs and the uncertainty surrounding daily negotiations with other countries.

Despite the market pullback, there are still significant short positions in the market, which could fuel another rally if the market starts to climb again. Bank of America’s trading desk believes that the short covering is far from over, as it would take more time to de-risk the market and reduce leverage significantly.

Overall, the market’s reaction to the short squeeze on Wednesday highlights the volatility and unpredictability of the stock market, with traders navigating through uncertain waters in search of profitable opportunities.