DELAFIELD, Wis. (Stockpickr) -- Short-sellers hate being caught short a stock that reports a blowout quarter. When this happens, we often see a tradable short squeeze develop as the bears rush to cover their positions to avoid big losses. Even the best short-sellers know that it's never a great idea to stay short once a bullish earnings report sparks a big short-covering rally.
This is why I scan the market for heavily shorted stocks that are about to report earnings. You only need to find a few of these stocks in a year to help enhance your portfolio returns -- the gains become so outsized in such a short time frame 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 off a short squeeze. This way, you're letting the trend emerge after the market has digested all of the news.
Of course, sometimes the stock is going to be in such high demand that you risk missing a lot of the move by waiting. That's why it can be worth betting prior to the report -- but only if the stock is acting technically very bullish and you have a very strong conviction that it is going to rip higher. Just remember that even when you have that conviction and have done your due diligence, the stock can still get hammered if Wall Street doesn't like the numbers or guidance.
If you do decide to bet ahead of a quarter, then you might want to use options to limit your capital exposure. Heavily shorted stocks are usually the names that make the biggest post-earnings moves and have the most volatility. I personally prefer to wait until all the earnings-related news is out for a heavily shorted stock and then jump in and trade the prevailing trend.
With that in mind, here's a look at several stocks that could experience big short squeezes when they report earnings this week.
My first earnings short-squeeze trade idea is Chinese online social media platform player YY (YY), which is set to release numbers on Wednesday after the market close. Wall Street analysts, on average, expect YY to report revenue of $121.71 million on earnings of 58 cents per share.
The current short interest as a percentage of the float for YY is extremely high at 16.9%. That means that out of the 27.42 million shares in the tradable float, 4.63 million shares are sold short by the bears. This is a large short interest on a stock with a relatively low tradable float. Any bullish earnings news could easily spark a solid short-covering rally post-earnings that forces the bears to cover some of their bets.
From a technical perspective, YY is currently trending above both its 50-day and 200-day moving averages, which is bullish. This stock has been uptrending strong for the last three months, with shares moving higher from its low of $51.084 to its recent high of $81.84 a share. During that uptrend, shares of YY have been consistently making higher lows and higher highs, which is bullish technical price action. That move has now pushed shares of YY within range of triggering a major breakout trade post-earnings.
If you're bullish on YY, then I would wait until after its report and look for long-biased trades if this stock manages to break out above some near-term overhead resistance levels at $81.84 to $82.54 a share and then above more resistance at $85.98 a share with high volume. Look for volume on that move that hits near or above its three-month average volume of 1.97 million shares. If that breakout triggers post-earnings, then YY will set up to re-test or possibly take out its all-time high at $90.93 a share. Any high-volume move above that level will then give YY a chance to tag and potentially trend well north of $100 a share.
I would simply avoid YY or look for short-biased trades if after earnings it fails to trigger that breakout and then drops back below some key near-term support at $74.21 a share with high volume. If we get that move, then YY will set up to re-test or possibly take out its next major support levels at its 50-day moving average of $71.77 to $67.50 a share, or even its 200-day moving average of $64.04 a share.