Solid-state lighting leader Color Kinetics (NASDAQ:CLRK) enjoyed a good day on the market yesterday as shares rose more than 13%, finishing trading at more than $22 a share. Analysts were generally pointing to a "short squeeze" as the reason for the jump, which leaves this Fool wondering: Why were the short-sellers shorting in the first place?

Solid-state lighting creates energy-efficient illumination with light-emitting diodes. Through recent advances in this technology, a full spectrum of colors can be achieved, allowing the technology to be used in televisions, movie screens, mobile phones, and around the house. LEDs last 20 times longer than regular incandescent light bulbs, and Color Kinetics has already installed its systems in Dave & Buster's restaurants, Harrah's (NYSE:HET) casinos, Marriott (NYSE:MAR) hotels, and Limited Too (NYSE:TOO) kids' clothing stores.

As competitor Super Vision (NASDAQ:SUPVA) has found out, Color Kinetics also has a formidable arsenal of patents, which it vigorously enforces. When Super Vision tried to claim that Color Kinetics had infringed on its patents, a judge not only shot down the claim, but also said that Color Kinetics was the real victim of infringement.

In this case, short-sellers were betting against the wrong horse. When you short a stock, you borrow shares from a broker and sell them to someone else who is going "long." Ideally, the stock will decline in price so that you can buy back the shares at a lower price and profit from the difference between your buying and selling prices.

There are situations in which shorting can be a valid strategy, as this article pointed out:

  • Companies in mature industries with little high-growth potential
  • Those that have a high debt-to-cash ratio
  • Those that have "jumped the shark," and have nowhere to go but down after reaching the pinnacle of their public lives

If we look at Color Kinetics, we see that the company does not fit any of those loose criteria. It is the leading provider in an industry that is only just taking off. Revenues for 2005 were up 32% over 2004, and analysts are predicting long-term growth of 50% over the next five years. The lighting specialist also has no long-term debt and more than $57 million in cash and short-term investments available to it. Color Kinetics is only just realizing its potential, and there's plenty more room to expand.

The short-sellers may have merely focused on the price of the stock, which has doubled from $10 to $20 a share over the past year. Basing a short decision simply on valuation, even if it seems a stock is richly valued and grossly overpriced, can be dangerous because stocks can remain that way -- if not grow even more so -- for long periods of time. If that happens, you can find yourself on the, um, "short" end of a short squeeze. That's where short-sellers are forced to buy their shares en masse, fueling a further jump in price and causing more short-sellers to cover.

That's what the analysts believe caused Color Kinetics' jump. On Monday, it was reported that the company was awarded another patent, and the stock rose by a dollar. Tuesday, the shorts started covering, buying back shares in hopes of cutting their losses; this drove the price up another $3 a share.

Since October of last year, the short interest in Color Kinetics has been high, with the days to cover being in the mid- to high teens. That's a tough place to play when you're dealing with a company that has lots of potential to brighten its future significantly, and it would seem that the risk has caught up with the shorts -- who now have a darker portfolio than before.

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Fool contributor Rich Duprey owns shares of Color Kinetics, but does not own any of the other stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.