Wall Street is off to a great start in 2021, including some stocks that were under heavy scrutiny coming into this year. Investors have noticed, and are looking to climb aboard stocks they think are poised to defy critics and rocket higher.

Fueling a lot of the excitement is GameStop (GME -1.68%), which surged 100% in two days in mid-January despite difficult business conditions and a lot of investors betting the stock would go down. GameStop continued to surge higher on Jan. 25, gaining 50% in premarket trading alone.

The number of people betting the stock would go down actually helps explain some of that remarkable gain, causing a so-called "short squeeze." The conditions are right for it to happen again, and send some other stock soaring higher. But investors need to be careful before they invest based on a belief it will occur with a particular stock.

Here are three things investors need to consider before getting too excited about a potential short squeeze.

Illustration of a stock chart.

Image source: Getty Images.

What's a short squeeze?

When you buy a stock, you are in essence betting it will go up. If you want to bet it will go down, you can "short" the stock instead.

Short-selling is when an investor borrows shares of a stock and immediately sells them, pocketing the proceeds. Of course, those shares that have been borrowed will eventually have to be returned, so the investor is committing to buy the stock back at a later date. The investor will make money on the short if the stock price goes down, meaning they can buy back the shares at a price lower than the price they sold them.

It's a risky way to invest. While investors who "long" a stock have unlimited potential gains and only have the money they spent to buy the stock at risk, the potential losses if a short goes bad are also unlimited. If you short a stock at $10 and it spikes higher, to say $100, you could be out $90 per share, well more than what you would have lost if you bought the stock at $10 and it went to zero.

For that reason, if a stock starts higher, those who are short will sometimes panic and quickly close out their position. That's a short squeeze.

What does a short squeeze mean for stockholders?

A short squeeze, at least in the near term, can send a stock that is already in rally mode into hyperdrive.

If shorts are rushing to close their positions when a stock is already trending higher, they are creating extra demand for the shares. Extra demand typically means higher prices.

Investors in Tesla (TSLA -3.48%) seemingly benefited from a short squeeze last year. Tesla in recent years has been a frequent target of shorts, and those who bet against it have paid dearly. Tesla shares are up 656% in the last 12 months.

TSLA Chart

TSLA data by YCharts

There were several reasons the stock climbed higher, but as the chart shows, the rising stock price coincided with a dramatic decrease in the number of shares short. Shorts covering, or closing their money-losing positions, likely created a short squeeze that helped provide the rocket fuel that propelled the stock higher.

Don't get complacent

Short squeezes and the subsequent surge higher are almost always a reason for celebration among holders of a stock. But they are, by their nature, not long lived, as there are only so many shorts who must cover only so much propellant.

Long-term investors should be cautious about getting too giddy about a short squeeze and losing focus on fundamentals. While short sellers sometimes make mistakes, there is likely at least some reason that they decided to bet against a particular company. A short-squeeze rally can sometimes cause complacency, which can harm investors over the long run.

Tesla hasn't shown signs of decelerating yet, but investors should also consider the example of First Solar (FSLR 1.53%). First Solar shares climbed more than 300% in a matter of months in early 2012, a period that coincided with the short interest in the shares cut in half from nearly 40% of the total to 20%. A similar pattern played out again a few years later. But until recently, the stock was largely range-bound during that entire period, with the stock weighed down by concerns over its business but at times surging higher thanks to squeeze rallies.

FSLR Chart

FSLR data by YCharts

More ominous, shares of Hertz Global Holdings (HTZG.Q) experienced a number of short covering-inspired spikes higher, prior to the company eventually filing for bankruptcy in May 2020.

Here's what to keep your eye on

With markets near all-time highs and many stocks seemingly defying the laws of gravity, there is a lot of talk among investors about short sellers waving the white flag and predictions for future short squeezes on the horizon to rival GameStop.

That may indeed happen. But it's also possible that just as quickly as this momentum appeared it will disappear, and stocks will rapidly give back gains in the months to come.

The best advice is the simplest advice: Find strong companies, and don't try to predict, or get too worried about, short-term price movements. A short squeeze can be an interesting footnote for a stock holding, but it isn't a good foundation for a long-term investment thesis.