A retail-fueled rally and AI exuberance turned 2025 into short sellers’ worst year of returns in half a decade

Traders who spent 2025 betting against the hottest corners of the U.S. equity market are limping into the fourth quarter, blaming a resurgent army of retail investors for one of the most unforgiving years since the meme-stock frenzy. A basket of the 250 U.S. stocks most popular with short sellers has surged roughly 57% this year, according to data cited by market analytics firm S3 Partners—an advance that turned many contrarian wagers into a costly ‘pain trade’ even as professional investors warned valuations had become stretched.

The story of 2025 is as much about psychology as it is about profits. As benchmark indices repeatedly printed record highs, fear of missing out kept retail flows robust. Commission-free trading, ubiquitous options access, and social media callouts amplified the momentum. Short positions—especially in smaller, volatile names with tight floats—became tinder for rallies. Each incremental price rise forced more covering, which in turn fueled even sharper gains.

AI optimism and the prospect of easier financial conditions provided the macro backdrop. A powerful bid for growth and software names spilled over into adjacent narratives—from data-center infrastructure to chip-adjacent plays and even speculative turnarounds. Heavily shorted stocks in these ecosystems became serial beneficiaries of ‘story over substance’ trades. AppLovin, for instance, saw eye-catching gains as bulls leaned into its AI positioning while skeptics questioned the durability of monetization. Elsewhere, flashpoint names such as Robinhood, Terawulf and Hertz whipsawed shorts after bursts of retail enthusiasm and news catalysts reignited animal spirits.

The mechanics were familiar, but the scale surprised veterans. Short interest clustered in pockets where free float was constrained and borrow costs were high, elevating the so-called ‘squeeze score’ of dozens of names. When prices jumped, negative convexity took over: mark-to-market losses tightened risk limits, risk managers demanded position cuts, and borrows were recalled just as liquidity thinned. The result was cascading cover-buying—and a feedback loop that pushed prices further from fundamental estimates.

For many discretionary managers, 2025 also exposed the limits of forensic short selling in an era dominated by passive and rules-based flows. Indexation and factor crowding can overwhelm idiosyncratic research for long stretches. Activist bears argued that markets no longer punish weak governance, thin cash flows, or promotional claims swiftly enough; their theses, they insist, still pencil out over a full cycle, but the mark-to-market cost of waiting has climbed.

The uncomfortable truth is that shorting individual equities has always been a structurally negative-expected-value business. The best-case upside is capped at 100%, while potential losses are theoretically unlimited; borrow fees and dividends owed create a persistent drag. Those headwinds multiplied in 2025 when momentum, FOMO and a friendly macro narrative lined up against them. Even systematic short-bias strategies struggled as correlations rose and leaders broadened beyond the mega-cap ‘Magnificent’ cohort.

Still, this cycle has had distinctive 2025 fingerprints. Option-driven flows—particularly short-dated call buying—added a layer of reflexivity. Dealers hedging their gamma exposure often had to buy into strength, mechanically lifting underlying prices. In thinly traded names, that dynamic can be explosive. Meanwhile, a drumbeat of ETF creation and factor rebalancing meant that flows linked to volatility, momentum and quality screens could smash into each other, exaggerating swings over month-end and quarter-end windows.

If retail investors have been the visible face of the rally, they were not alone. Large institutional allocators continued to add to technology and growth exposures into strength, according to prime-brokerage flow data. Short-bias exchange-traded funds even saw bursts of inflows late in the summer and early autumn—evidence that a cohort of investors was actively positioning for a reversal. Ironically, those hedges may have provided incremental fuel for rallies when markets squeezed higher and short hedges were unwound.

Where does the market go from here? Valuations in select pockets remain strenuous, but the tale of 2025 has been less about earnings revisions and more about the dominance of flows, positioning and narratives. A durable reversal would likely require a decisive shift in one or more of those—perhaps a renewed rise in real yields, an earnings wobble in a marquee AI name, or regulatory scrutiny that dents some of the most speculative stories. Absent that, bears face the same asymmetry that punished them all year: each downtick must be traded with discipline, while every uptick threatens to snowball.

For risk managers, three lessons stand out. First, be humble about time horizons: even high-conviction forensic shorts can be steamrolled by flows for longer than models assume. Second, size with the squeeze in mind—monitor borrow availability, liquidity at risk, and option-implied move distributions, not just valuation gaps. Third, diversify the ‘why’ behind a short: fraud, governance, cyclical decline and balance-sheet stress behave differently under stress; lumping them together invites correlated drawdowns.

For retail traders, the temptation will be to declare victory. Some have indeed enjoyed outsized gains, and a number of 2020-era communities reassembled this year with fresh playbooks in options and crypto-adjacent trades. But momentum cuts both ways. The same reflexive dynamics that turbocharged 2025 winners can invert when liquidity vanishes and basis risks bite. A discipline built on risk limits, not hashtags, is the difference between a bull-market hero and a round-trip cautionary tale.

The final word belongs to the calendar. As the year turns, the market will test whether 2025’s squeeze was a late-cycle excess or the early innings of a more durable regime in which flows and narratives routinely outrun fundamentals. If the latter, short selling will not disappear—but it will demand lighter feet, smarter hedges and extraordinary patience. In this market, being right eventually was no consolation for being wrong today.