Stock Quotes in this Article: KBH, RT, SVU

WINDERMERE, Fla. (Stockpickr) -- Is there anything worse for a trader than being short a stock into an earnings report that surprises Wall Street and announces bullish fundamentals?

Sure, there is: when those bullish fundamentals are enough to spark a massive short squeeze, sending the stock higher as bears are forced to cover their short positions due to an imbalance in supply and demand on the stock.

Of course, if the company disappoints, then the bears have a license to hammer a stock with a high short interest significantly lower. That's why it's smart to scan the market for potential earnings short-squeeze candidates and pick the names that are displaying the best price action on strong volume going into their reports. These are the names that have the highest probability for an earnings short squeeze -- and for making a trader a lot of cash on the quick.

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    There are a number of strategies that investors can deploy on heavily shorted stocks heading into their earnings reports. One strategy is to buy the stock ahead of the report looking for a big squeeze if you think the company is going to deliver strong results. I would advise readers to look for heavy volume above the three-month average daily activity on any stock that you use this strategy with. Also, that volume must be confirmed by bullish upside price action. If you don’t see these characteristics, then I would wait for the report and see what transpires before placing your bets.

    Another strategy is to just wait for a company to report its numbers and witness strength in a stock before jumping in to ride the momentum and potential short squeeze. There’s nothing wrong with getting conformation of the move first and missing some of the initial upside just to make sure you’re on the right side of the trend.

    One more strategy is to use options to either hedge your position or just to buy outright bullish exposure on a stock before a company reports its earnings.

    Here's a look at some stocks that could experience a big short squeeze when they report earnings.

    Ruby Tuesday

    My first idea for an earnings short squeeze trade is Ruby Tuesday (RT), which together with its subsidiaries develops, operates and franchises casual dining restaurants in the U.S., Puerto Rico, Guam and internationally. The company operates its restaurants under the Ruby Tuesday brand and also owns and operates two Wok Hay restaurants. Ruby Tuesday is set to report earnings on Jan. 5 after the close of the market. Wall Street analysts are looking for the company to report revenue in a range of $277.80 million to $281.80 million.

    On Monday, an analyst at Morgan Keegan upgraded the stock to outperform, citing the company’s plans to improve sales and profits at its core restaurants, convert underperforming Ruby Tuesdays to other brands and build new Lime Mexican Grill restaurants to drive growth. Following the upgrade by Keegan, the stock had one of its highest-volume days in the past few months after 1.4 million shares changed hands as the stock closed up a dollar. That 1.4 million in volume was well above the three-month average daily volume activity of around 533,000 shares.

    Currently, the stock is trading very close to its 52-week high of $14.53 at around $14 a share. Shares of Ruby also broke out above some previous overhead resistance at around $14.06 on Monday, which bodes well for higher prices if the stock can continue to trade above that breakout level heading into the report. This solid technical picture shows that Ruby Tuesday has some momentum and relative strength as we near their earnings report.

    As long as the stock stays above its 50-day moving average of $13.01 and stays above that breakout level of $14.06 prior to its earnings report, then we could see a nice short squeeze develop here.

    The current short interest as a percentage of the float for Ruby Tuesday is around 6.5%, which means that out of the 55 million shares in the public float available for trading, around 3.6 million shares are currently sold short as of Dec. 15. This is a notable short interest on a stock with a relatively low float. This low-float situation at Ruby means that the stock could see a material short squeeze develop if the company reports some bullish fundamentals that gets the bears nervous about their bets.

    If you want to play Ruby prior to its earnings report, then I would look for the stock to move back above the breakout point of $14.06 on volume well above 533,000 shares. Or look for the stock to start hitting new 52-week highs right before the earnings report. Either of these technical scenarios should bode well for a large short squeeze in Ruby Tuesday.

    Major Ruby Tuesday bulls include Robert Olstein at Olstein Financial Alert Fund. The stock was recently include in a list of 10 restaurant winners of 2010. TheStreet Ratings has a C hold rating on the stock.

    KB Home

    Another potential earnings short squeeze trade is KB Home (KBH), which operates a homebuilding and financial services business serving homebuyers in markets nationwide. It constructs and sells homes through its operating divisions across the U.S. under the name KB Home. The company is set to report earnings on Jan. 7 before the market opens. Wall Street analysts are looking for revenue to come in between a very wide range of $377.49 million and $484 million.

    I am not a fan of the housing market for various reasons, not least of which the oversaturation of new houses by builders -- such as KB Home -- during the boom times. The government's intervention into the market has done very little to improve the price destruction. However, I'm interested in trading stocks, not trading my opinion, and I recognize that the bearish overhang on the builders could set up some of the stocks for notable short squeezes.

    A company as beaten-down as KB Home doesn't have to beat earnings expectations to spur a short squeeze; it just needs to paint a bullish enough picture going forward and give Wall Street some guidance that a recovery for housing is under way and on track for 2011. It doesn't need to beat earnings; it just needs to avoid an earnings miss.

    If KB Home's management is smart, it's rid itself of unsold inventory and moved into the growth markets around the country where houses are still in reasonable demand. It would also be helpful if the company has reduced costs and streamlined their operations to fit the current challenging housing environment. Any improvements in these areas could be enough to spark an earnings rally on the stock.

    The current short percentage of the float for KB Home is a rather large 23.2% as of the most recent reporting period of Dec. 15. That means that out of the 61.12 million share tradable float around 17.73 million shares are currently sold short by the bears. This is another case of a very low-float, high-short-interest stock that could easily see a large short squeeze if the company can deliver a decent fundamental result.

    From a technical standpoint, the stock is on the cusp of a breakout if the stock can manage to trade above some previous overhead resistance at around $14.26 a share. A move above that level prior to KB Home's earnings report should set the stock up for a big short squeeze because it would demonstrate that the bulls have some near-term control over the stock. What I would suggest to traders is to watch for a breakout above $14.26 on volume notably above the three-month average daily action of 2.6 million if you want to play this one into earnings on the long side.

    Making a major bullish bet on KB Home is Arnie Schneider at Schneider Capital Management, who increased his position in the stock by 7% in the most recent reporting period. Jake Lynch recently include the stock in a list of 10 unloved stocks that could rise up to 120%. TheStreet Ratings has a D sell rating on KB Home.

    SuperValu

    One final stock that could be setting up for a big earnings short squeeze is SuperValu (SVU), which operates food retail stores in the U.S. under the banners of Acme, Albertsons, Jewel-Osco and Save-A-Lot, to name a few. The company is set to report earnings on Jan. 11, and Wall Street analysts are looking for revenues to come in between $8.59 billion to $8.96 billion.

    The stock was hit with two nasty downgrades on Tuesday by analysts at BMO Capital Markets and Morgan Stanley. BMO Capital said that several grocery store stocks, including Supervalu, are struggling due to intense competition, food price fluctuation and limited consumer spending. Morgan Stanley downgraded the stock citing rising food costs which threaten to hurt their profits if they’re not able to raise prices.

    Here’s my take: Yes, food costs are definitely set to go higher in 2011 due to rising soft commodity prices. However, unless the world has a new way for people to buy food besides going to grocery stores, I don’t see how these companies will have too much trouble passing those rising costs along to consumers.

    In fact, I think rising food costs will hurt casual dining restaurants stocks much more because people are going to cut back on discretionary spending at those outfits and move back toward grocery stores, which offer more price and product diversification. Remember, consumers can easily switch to off-brand products, which are cheaper and in many cases just as good as the top brands. Sure, this could in turn hurt margins at grocery stores such as SuperValu, but if they can capture enough of the casual dining market share, then the volume should make up for any margin declines.

    As of Dec. 15, the current short interest as a percentage of the float for SVU is a whopping 13.6%. That means that out of the 210 million shares in the tradable float, around 28 million shares are currently sold short by the bears.

    One of the reasons the stock is so heavily shorted is the massive debt SuperValu incurred when the company bought out Albertsons in 2006. The current debt on the books at SuperValu is over $7 billion, and the company has only around $203 million in cash. Clearly, SuperValu is overleveraged, but if it can show some sales improvements in the coming quarter, the stock should see a nice short squeeze. Shares are also cheap trading at a forward price-to-earnings of 5.99, with a reasonable market cap of only $1.9 billion.

    From a technical standpoint, as long as the stock doesn’t trade below $8.20 a share, it could be a solid short-squeeze play going into its earnings report. It would also be helpful for the bulls if the stock could get back above its 50-day moving average of $9.53, which isn’t far off with the stock currently trading around $9 a share. The downgrades hit the stock with a lot of volume selling on Tuesday, but if you don’t see that volume selling continue in the following days, it could market a short-term bottom for the stock heading into the earnings report. The average three-month trading volume is around 6 million shares, so that’s the amount to watch for on down days in the next few trading sessions.

    According to Jake Lynch, SuperValu was one of the worst-performing S&P 500 stocks of 2010. It has a D sell rating from TheStreet Ratings.

    To see more potential earnings short squeeze candidates, check out the Earnings Short Squeeze Plays portfolio on Stockpickr.

    -- Written by Roberto Pedone in Winderemere, Fla.

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    At the time of publication, author had no positions in stocks mentioned.

    Roberto Pedone, based out of Windermere, Fla., is an independent trader who focuses on stocks, options, futures, commodities and currencies. He is also an outside contributor to Beconequity.com and maintains the website Maddmoney.net, which he sold to Blue Wave Advisors in 2008. Roberto studied International Business at The Milwaukee School of Engineering, and he spent a year overseas studying business in Lubeck, Germany.