Editor's note: As part of our partnership with Nightly Business Report, TheStreet's Bob Walberg appeared on NBR Monday (see video and transcript here) to look at stocks with short-squeeze potential this earnings season.
NEW YORK ( TheStreet) -- Europe's a mess, Chinese growth is slowing down faster than expected, the domestic recovery is in its infancy and we are about to enter a traditionally slow seasonal period for the market. It's no wonder investors are selling stocks. But there's a big difference between selling to lock in gains or to shed a loser and selling short.
Selling short means that an investor borrows stock to sell at today's price, with the intention of buying it back in the future at a lower price. The short investor is betting that the price of the stock in question will decline. However, if the price of the stock should go up instead of down, at some point that investor will be forced to buy back his stock to limit his loss.
Naturally, the more people are forced to cover their positions on the way up, the more the buying pressure will propel the stock higher. This action is what is commonly referred to as a "short squeeze."
Anticipating a short squeeze can be a very profitable way to play the market, and there is no better time to employ this strategy than during earnings season. Earnings provide a catalyst for action and if the short sellers are proven wrong by a stronger-than-expected quarter, they will start to aggressively cover their positions, thereby triggering the aforementioned squeeze. We have seen such activity play out routinely in stocks such as Lululemon (LULU), Chipotle Mexican Grill (CMG), Intuitive Surgical (ISRG), etc.Admittedly, stocks are often shorted for good reason -- management issues, accounting irregularities, hyper-valuations. Nevertheless, if you can identify a candidate that defies the skeptics, the surge to new heights can prove very, very rewarding. Just look at the charts of the three examples cited above. When looking for short-squeeze candidates, you first want to find stocks that are very heavily shorted. You can find this data relatively easily on popular free investing sites such as TheStreet or Yahoo! Finance. Then you want to find stocks that are either in the early stages of growth -- where upside sales or earnings surprises are common -- or at rock-bottom -- where the selling is pretty much exhausted, and even bad news doesn't have the desired downside impact. Looking at the current list of heavily shorted stocks, three names jump out at me as being good candidates for a short-squeeze rally: Skullcandy, DreamWorks Animation SKG and KB Home.