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The ONE Thing that Could Ruin a Great Investment

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It's always intriguing to look at the list of the most heavily-shorted stocks. Many investors like to see which companies are expected to tumble by various short-interest gauges. Owning these stocks long-term can give pause, and perhaps a reason to sell if short sellers' arguments appear to be on the mark. Other investors use the list of the most heavily-shorted stocks to find short candidates themselves. And that's a huge mistake. That's because the most-heavily shorted stocks are often the biggest gainers when major events come to pass.

We've seen this phenomenon again in recent days. On Tuesday morning, April 10, distressed grocery chain Supervalu (NYSE: SVU) weighed-in with quarterly results. They were pretty bad, but perhaps not as bad as the most aggressive short-sellers assumed. These short sellers had been holding 73 million shares in short accounts, making this the fourth most-shorted stock on the New York Stock Exchange. That short interest equated to an eye-popping 14 days' worth of trading volume.

Simply delivering bad but not horrible earnings led investors to embark on massive short-covering. By the end of trading on Thursday, shares had risen a hefty 23%. Some of that upward spike surely came from short-sellers covering their position by buying back borrowed stock. Roughly 10 million shares traded hands daily going into the quarterly report, though that figure spiked to 38 million on the day results were released.

Later that day, Alcoa (NYSE: AA) weighed in with results that were better than analysts had forecasted. As the fifth most heavily-shorted stock on the market, it should come as no surprise that shares quickly zoomed higher and are now up nearly 10% in the last few trading sessions.

The key takeaway: it might be wiser to see if heavily-shorted stocks have more upside than the short-sellers might think. If so, those shorts may unwittingly force shares up for you with all of their buying efforts as they cover positions.

This is food for thought as we head into the teeth of the earnings season. Here are some of the top targets for short sellers, and the expected dates for them to report results.

Risks and rewards...

Safeway (NYSE: SWY), another heavily-shorted grocer, also highlights the risk of betting against such stocks. Rumors have swirled that the company may get acquired, and these rumors appear to have little merit. Still, just the rumor has likely spooked short-sellers, and shares are now up for four straight sessions (at the time of this writing).

To be sure, some companies appear to deserve to attention of short-sellers. For example, I laid out the long-term threats in place for video-game retailer Gamestop (NYSE: GME) back in October 2011, and though shares are off more than 10% since then (as the broader market has moved steadily upward), recently released sales data imply even worsening quarterly results in the periods ahead. Sales of video games and consoles slid sharply in March, according to NPD Group, and it's getting harder to see how this company can earn more than $3 a share in fiscal (January) 2013 and 2014, as analysts currently anticipate. Still, with such a huge short position in place, it may be wiser to sell this stock (if you own it long) and then short it outright.

Profiting from the "short squeeze"
If you want to angle to profit from a potential short squeeze, it makes sense to target stocks that have huge short positions in relation to their daily trading volume (known as "days-to-cover").

These stocks include:

St. Joe (NYSE: JOE), a real-estate concern, with 36 days to cover
• Briggs & Stratton (BGG), small engine maker, with 28 days to cover
Meredith Corp (NYSE: MDP), a media firm, with 27 days to cover
• American Greetings (NYSE: AM), which makes greeting cards with 26 days to cover.

You should only look to go against short sellers with these stocks if your own research provides a clear case that business trends are OK and not in trouble as short sellers likely suspect.

Risks to Consider: It only pays to focus on a potential short squeeze if you think the market is going higher. A slumping market could well prove these short-sellers right, even if they're wrong.

Action to Take --> You should always check the size of the short position before investing in any stock. If you're going long, then you'll want to at least know what the shorts are thinking. And if you're thinking of going short, tread very carefully, lest you get caught up in a short squeeze if the total short position is already quite large.

[Note: If you haven't heard about this unique opportunity, then I want to tell you about it now. StreetAuthority has staked me with $100,000 of real money to invest in my absolute best ideas. For a limited time, you'll be able to follow along with me completely free. Go here to learn more.]

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. 
StreetAuthority LLC does not hold positions in any securities mentioned in this article. 

This article originally appeared at www.streetauthority.com.

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