Don't Sell a Short-Seller Short

Plenty of people think they have the secret to finding stocks that will make them rich. One of the more unusual ways to try to identify stocks poised for quick gains is by buying stocks that are ripe for a short squeeze. These intrepid speculators find companies targeted by short-sellers and buy the stock, hoping to start a chain reaction that will quickly drive the price up.

Before you can understand a short squeeze, you have to know what short-selling is. A short-seller borrows shares of stock from someone and then sells them. After a while, he buys the stock back and returns the shares to their original owner. If the stock price has fallen, the short-seller makes a profit; but if the stock price has increased, the short-seller loses money.

This method is risky -- if the stock price doubles or triples between when he sells the stock and when he buys it back, he can lose more than the original value of the stock. That's why other Fools have advised against shorting stocks, and I suggest heeding their warnings.

Anatomy of a short squeeze
Some speculators think that when there's a lot of short-selling in a particular stock, it's a bullish signal. They reason that the short-sellers will eventually have to cover their short positions by buying stock, and that buying will in turn push the stock price higher.

What these speculators hope is that if they buy the stock, it will push the price up, creating paper losses for short-sellers. In response, some short-sellers will buy back the shares, either to limit their losses or because they're forced to meet margin calls. The short-sellers' buying pushes the stock price further up, which causes even more short-sellers to buy to cover. It's a vicious cycle for short-sellers. This is the quintessential short squeeze.  

The shorts usually win
The problem with this strategy is that the short-sellers are usually right. It isn't hard to see why -- because short-selling is so difficult, only the best will succeed and continue to do it. The strategy quickly weeds out the inept.  

I decided to do my own little study of the fates of highly shorted companies. Using the work of other Foolish writers, I came up with 15 heavily shorted stocks from earlier this year. I decided to see how each of those stocks fared against the overall market by comparing the returns against the Dow Jones Wilshire 5000, which is a broad index of the overall stock market. As you can see from a sample of those stocks below, some of the results were astounding.

The average return of those 15 heavily shorted stocks mentioned last March and April in those Foolish articles was a loss of 5.6%, versus an average positive return of 5.4% for the stock market (averaging across different start dates). Therefore, the stocks that were heavily shorted underperformed the market by an average of more than 11% in the last six months or so.

Another interesting finding is that for these stocks with high short-interest, the CAPS rating was a strong predictor of performance. In general, stocks rated one star returned a loss of 22%, while those stocks rated three stars or higher returned 17.1%, beating the market. The moral of this story is to stay away from stocks hated by almost everyone, as indicated by short-sellers and CAPS players.

I don't know about you, but I have no interest in betting against well-informed people who tend to be right. So the next time you think of buying a stock, check out the short interest. And remember: Those short-sellers may know something, so don't let them squeeze you.