A short squeeze is a market phenomenon where securities that are heavily shorted experience rapid and tremendous rallies in the wake of positive news. To see a short squeeze in action, look back a few weeks to Netflix’s last earnings report: Shares nearly doubled in the wake of earnings that exceeded Wall Street’s expectations. It wasn’t purely that the quarter was so tremendous; rather, so many shares had been sold short that Netflix bears were left scrambling to cover.
Short squeezes are notable in that they work on a positive feedback loop. One trader covers his short, which raises the price. This new, higher price is seen by a second trader who is short. The second trader is then prompted to cover, raising the price of the underlying security further still.
Depending on how many shares are sold short, this process can be powerful and propel shares of heavily shorted companies to vast heights — particularly if much of the covering is done involuntarily (margin calls).
Can short squeezes be predicted?
To some extent, short squeezes can be foreseen in advance: Any heavily shorted stock about to face significant news could feel the effects of a short squeeze. Traders who don’t mind a high degree of risk could purchase out-of-the-money (OTM) calls on these securities ahead of the news. OTM Netflix calls, for example, gained hundreds of percentage points the day after the company’s earnings report.
To be fair, however, stocks that are heavily shorted are frequently done so for particular reasons. Perhaps the company is trading at a mind bogglingly lofty valuation. Perhaps the business model is fundamentally broken, or the company is under legal scrutiny.
Whatever the case, these companies face real challenges. Should the news come in negatively — as the shorts anticipate — shares could take a massive leg down.
Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR)’s short float is about 25%
Roughly 25% of the the single-serve coffee giant’s shares have been sold short. The most notable bear is hedge fund manager David Einhorn, who gave a presentation back in the fall of 2011 laying out his short thesis.
In a recent investor letter, Einhorn hinted that he remains short: He admitted that, unfortunately, he was burned by the short position in the fourth quarter of 2012 when shares of Green Mountain roughly doubled.
Green Mountain is set to report earnings on Wednesday. Analysts currently expect the company to post an earnings per share figure of $0.65 on revenue of $1.33 billion. Anything more than that, and shares could soar.
Yelp Inc (NYSE:YELP)’s short float is roughly 27%
Yelp has a host of challenges. To start with, the company is a recent Internet IPO, along with Groupon, Facebook and Pandora — companies that have all seen their share price collapse following their IPO.
Further, Yelp isn’t making money, in fact it’s losing it. Analysts expect the company to report that it lost $0.04 per share this quarter on revenue of $40.29 million.
Its business — a sort of online yellow pages for restaurants and entertainment venues — faces growing threats from a host of competitors such as Google’s Zagat, or Facebook’s coming social graph search (shares of Yelp nose dived the day Facebook’s graph search was unveiled).
Still, with well over one quarter of shares sold short — about 27 percent — positive earnings (or even break-even) combined with decent guidance could have shorts running for the exits, and shares of Yelp soaring.
Yelp, like Green Mountain, is expected to report earnings Wednesday.
Zillow Inc (NASDAQ:Z) has the highest short float on this list, a whopping 36%
Like Yelp, Zillow is also a recent Internet IPO. To date, shares have had a bumpy ride, but are up over 7% since the company went public in the summer of 2011. In the last month, shares have gained more than 24%.
Zillow’s short float is notably higher than both Yelp’s and Green Mountain’s. More than one-third of Zillow’s shares have been sold short, about 36%. This makes it one of the most heavily shorted stocks on the Nasdaq.
Besides its status as a high-flying Internet IPO, shorts may be targeting the company due to its current valuation: Zillow trades at a P/E of 179.76 (based on Monday’s closing price of $36.82).
Zillow is set to report earnings next Wednesday, February 13. Analysts are currently expecting break-even earnings on $31.47 million worth of revenue.
Besides an upside earnings surprise, Zillow has also been linked to a number of takeover rumors, although nothing definitive has surfaced.
In the end, while short squeezes remain an unpredictable phenomenon, there are clues investors can look for to identify them in advance. Traders looking to take advantage of a short squeeze should keep their eyes peeled for stocks that are heavily shorted facing significant upcoming catalysts, such as earnings reports. Should these catalysts prove bullish, many of the short sellers could find themselves running to cover — in the process driving shares up to new highs.
The article Three Stocks Primed for a Short Squeeze originally appeared on Fool.com and is written by Salvatore “Sam” Mattera.
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