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WINDERMERE, Fla. ( Stockpickr) -- News events have the power to create big volatility in stocks, and one event that can move them substantially higher or lower is an earnings release. Combine a bullish earnings report with a stock that's heavily shorted, and you have the fuel to ignite a large short squeeze.
Short-sellers hate being caught short a stock that announces bullish earnings and forward guidance. When this happens, we often see a tradable short-squeeze develop as the bear rush to cover their positions and avoid huge losses. Even the most skilled short-sellers know that it's never a great idea to stay short once an earnings event sparks a big short-covering rally.
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This is why I scan the market for heavily shorted stocks that are about to report earnings. You only need to find a couple of these candidates in a year to help enhance your portfolio returns; the gains become so outsized in such a short timeframe that your profits add up quickly.
That said, let's not forget that stocks are heavily shorted for a reason, so you have to use trading discipline and sound money management when playing earnings short-squeeze candidates. It's important that you don't go betting the farm on these plays and that you manage your risk accordingly. Sometimes the best play is to
wait for the stock to break out following the report before you jump in to profit from off a short squeeze. When you do this, you're letting the trend emerge after the market has digested all of the news.