For many investors, their primary means of making money in the stock market involves buying a stake in a company and holding that stake for a period of time before selling. But there are two sides to every trade, which means there's an opportunity to make money when equity prices are falling, as well.

Short-sellers are investors who make money when the share price of a stock falls and lose money when it rises. But unlike buying and holding a stock, short-selling comes with its own unique risks.

For example, the worst thing that happens when you purchase shares of a company is that it goes bankrupt and you've lost your initial investment. Meanwhile, gains are limitless, since there's no ceiling to how high a stock's share price can go. Conversely, short-sellers can do no better than a 100% return on their investment, while their losses are unlimited. Were this not enough, shares sold short are also borrowed from an investors' brokerage, which means the individual is paying margin interest on the value of what's been borrowed.

Despite these risks, short-selling plays a key role in price discovery -- i.e., determining a "fair value" for the share price of equities.

Two diverging charts leading to a digital rocket.

Image source: Getty Images.

Retail investors are eager to find the next short-squeeze candidate

But over the past four months, short-selling has ignited a fire among the retail investor community on social media. Specifically, retail investors on community chat platforms like Reddit are on the lookout for the next great short squeeze.

Without getting too far into the weeds, a short squeeze is an event where a rising share price and a perfect set of conditions and catalysts cause short-sellers to feel trapped into their positions. These pessimists respond by rushing for the exit all at once. In order to get out of a short-sold position, short-sellers must buy shares, which can lead to runaway upside in an already overheated share price. We saw dozens of instances of heavily short-sold companies skyrocketing earlier this year, including GameStop (NYSE:GME), AMC Entertainment (NYSE:AMC), and Sundial Growers (NASDAQ:SNDL), to a name a popular few.

However, sustained short squeezes don't occur simply because a company has a high level of short interest. To effect moves like we witnessed earlier this year, a company needs a high short ratio, which is also known as "days to cover."

In simple terms, the short ratio describes how long it would take all short-sellers to cover if they suddenly wanted out, relative to the three-month average daily trading volume for a company. If 10 million shares were held short and the three-month daily average trading volume was 2 million shares, the short ratio would be 5, or five trading days to fully cover. The higher the short ratio, the longer it'll take pessimists to cover their positons -- ergo, the most likely they are to feel "trapped" by a sudden surge in a company's share price.

A small pile of one hundred dollar bills on fire.

Image source: Getty Images.

Betting on a short squeeze has not been wise

Right now, retail investors on Reddit are seemingly living and dying by short-squeeze data. But there's one important metric they're overlooking: performance.

Using data from Finviz, I pulled up the trailing three-month performance of the 114 stocks with a market cap of at least $300 million and short interest, relative to float, of at least 20%. In other words, these are the types of heavily short-sold stocks being targeted for squeezes by retail investors.

With the S&P 500 up by approximately 6% over the trailing three months, here's how heavily short-sold stocks have performed, through May 11, 2021:

  • 27 of 114 (24%) are down by at least 50%
  • 47 of 114 (41%) are down by at least 40%
  • 63 of 114 (55%) are down by at least 30%
  • 94 of 114 (82%) have a negative trailing three-month return
  • 100 of 114 (88%) have underperformed the S&P 500's 6% three-month return
  • 9 of 114 (8%) have delivered gains of at least 10%

To summarize the data succinctly, it's been a really bad idea to base your investment solely on the hope that a short squeeze is coming.

A person holding a magnifying glass above a company's balance sheet.

Image source: Getty Images.

But wait -- there's more

Think about it this way: Short-sellers aren't going to pile into a company if there's not a concern about its operating performance, balance sheet, valuation, or perhaps all three. Just like a regularly paid dividend serves as a beacon to investors that a company is profitable and time-tested, a high short interest serves as a potential warning to investors that there are red flags to be wary of. This doesn't preclude companies with high levels of short interest from seeing their share prices go up. However, it does serve as a blatant warning that there may be serious issues affecting an underlying company.

For example:

  • GameStop waited far too long to shift to a digital gaming model. Despite closing 12% of its stores last year and nearly tripling its e-commerce sales, total revenue declined by more than 21%. GameStop has plenty of cash, but it's going to be a while before it's profitable and growing again. That makes it a logical target for short-sellers following its 3,000% move higher over the trailing 12 months.  
  • AMC Entertainment is mired in a heap of debt and its first-quarter operating results showed it to be on pace to pay more in interest expenses in 2021 than it's generated in cash from operations in even its best years. That's not a sustainable business model. Couple this with a nearly two-decade decline box office ticket sales and it's easy to see why short-sellers have piled into AMC.
  • Sundial Growers has ample cash, but it's only raised this capital by diluting the daylights out of its shareholders. More than 1.15 billion shares were issued in five months. Were this not enough, Sundial's board OK'd another $800 million in at-the-market offerings. Marijuana stock Sundial has yet to prove anything to Wall Street with its income statements.

To boot, short squeeze metrics aren't that important. They tell you absolutely nothing about the state of a company's underlying business, which is what makes a company tick. Betting on a short squeeze without understanding the inner-workings of a company isn't a smart move -- and the performance data confirms it.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.