Stock Quotes in this Article: NILE, RAX, TSLA

WINDERMERE, Fla. (Stockpickr) -- Heavily shorted stocks that end up being bad bets by the bears can turn an investment or trade into a gigantic gain in a very short time frame.

This is one of the main reasons why shorting a stock is a very risky endeavor, even for the most sophisticated market player. Just consider the risk/reward of shorting a stock that isn’t quantifiable on the upside and is limited to a 100% return on the downside. When I say it isn’t quantifiable, I mean that a stock can go up as high as it wants to, but again, it can only drop 100% from the level where you shorted it. To hit the jackpot and score the 100% kill on a short sale, you have to identify the next Enron or WorldCom, which isn’t an easy task by any means.

Of course, there are other ways to short stocks that can produce big returns with less risk, such as purchasing put options on a name you think is poised to drop big. Investors can also deploy certain options spread strategies that will allow them to reduce risk and still profit from the decline in a stock price. These strategies can leave you less exposed to big losses from bad short bets and they still can’t produce the huge gains you can reap from being a part of big short squeezes.

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    I think that the majority of market players are better served by focusing on stocks that have the potential to short squeeze and punish the bears over pulling the trigger and shorting stocks that might be mispriced and due for a fall. I am not saying to never short stocks, but I do think its better strategy to look for short squeeze opportunities first. The main reason I use this approach in my own trading is that the market has an upward bias. My take here is that market players should master the short squeeze strategy first before they undertake shorting stocks.

    That said, don't become a robot and believe that stocks will only go up because that type of Pollyanna view will get you killed on Wall Street.

    There are so many heavily shorted stocks that have absolutely annihilated the bears this year. Just look at Netflix (NFLX), OpenTable (OPEN), Coinstar (CSTR) and Wynn Resorts (WYNN). All of these stocks have been horrible short sales this year and again prove why it’s much more advantageous to identify short squeeze candidates.

    With all of this in mind, here's a look at a few stocks that could be ripe for big short squeezes.

    One stock that is heavily shorted and could continue to squeeze the shorts is the largest online retailer of diamond engagement rings Blue Nile (NILE). This company is sitting in the sweet spot as an online retailer of diamondsand jewelry, with a particular focus on engagement diamonds and settings. Blue Nile is an expert at offering its clients jewelry products that hit just about every price segment. Customers can go to Blue Nile’s Web site and build their own rings, buy engagement rings and even purchase Blue Nile’s own signature diamonds. Just a quick browse of the site, and you’ll see that this company clearly knows now to market all kinds of options to its customers.

    The company’s CEO, Diane Irvine, recently told investors that Blue Nile had a record Thanksgiving and Black Friday, in terms of both sales and traffic. Irvine credited the company’s success with its move toward offering its products on mobile platforms such as its Blue Nile smartphone app. She mentioned that more than 25% of the company’s Web traffic is now coming through smartphones. Also, Irvine pointed out that their mobile customers spend significantly more than a traditional Web customer.

    I really don’t see why the shorts are targeting this stock other than for a trade on valuation. The stock currently trades at a trailing price-to-earnings of 69 and a forward price-to-earnings of 54. Granted that’s a premium valuation for a company that isn’t blowing away Wall Street with huge revenue growth yet. However, my take is that if the bears are shorting due to valuation, then they’re looking at this stock with a rearview-mirror approach. What’s intriguing about Blue Nile is that the company could be very early into its growth cycle when you consider that it's just entering the app game and has also just jumped into the social media via Twitter and Facebook.

    If Blue Nile can leverage its robust Web site with social media and creative marketing, then the growth could be huge for this company going forward. I also like the future growth prospects for Blue Nile because the company hits just about every price point with its product offerings, as I mentioned above. This should give Blue Nile a wide ranging customer base, which is already showing signs of development with the more than 90,000 people who have “liked” its Facebook page.

    The current short interest as a percentage of the float for Blue Nile sits at an unbelievable 40.8%. That’s a huge bet by the bears. If it turns out to be the wrong trade, which I think it will, then this stock is going to go up significantly. I would like to point out that this stock once traded for over $100 a share. My take is that Blue Nile is well on its way towardssqueezing the shorts and returning to those lofty levels.

    Another stock that’s heavily shorted by the bears that just baffles me is Tesla Motors (TSLA). This company designs, develops, manufactures and sells fully electric vehicles and electric powertrain components. Tesla is most famous for its electric car, the Tesla Roadster, which costs around $109,000. The company is also planning to launch a $57,000 five-door midsized sports luxury sedan called the Model S in 2012. Tesla recently outlined an aggressive timeline for the production of the Model S due to the already high demand for the car. Tesla has said that it's already received around 3,000 deposits for the Model S, at $5,000 or more apiece.

    Now, the naysayers are going to say this stock is way too risky because the company doesn’t have any earnings yet and we just don’t know if it can mass-market its electric cars. Plus, the company is burning through its cash as it races to develop its product lines. But the problem with that argument, in my opinion, is that the short-sellers are way too early to this story and are betting that Tesla isn’t innovative enough to make a go of it.

    What the naysayers fail to realize is that Tesla is looking for revenue sources from a number of different product and technology offerings. For example, Tesla isn’t just making electric cars; it's also getting into building electrical systems such as the one it's developed for the new Toyota Rav4 sports utility vehicle. Tesla is already projecting $60 million in revenue from the Rav4 alone. Let’s also not forget that Toyota (TM) clearly sees potential in Tesla as demonstrated by its modest $50 million stake in the company. This is the kind of corporate sponsorship that investors should look for in a young growth company.

    The current short interest as a percentage of the float for Tesla is 17.8%. I think the shorts are dead wrong to bet against this stock. They’re shorting a company that has the potential to be a market-breaking innovator with way more upside than downside potential.

    One more caveat to consider is how popular Tesla’s products will be if oil trades back over $100 a share and the price for gas skyrockets. Do you really want to be short a company that reduces costs for consumers in a world of high energy prices? I know that I don’t, so to the bears on Tesla, I say good luck with those short bets.

    Another stock that’s heavily shorted and just makes no sense to me is Rackspace (RAX). This company operates in the hosting and cloud computing industry. It provides information technology as a service, managing Web-based IT systems for small and medium-sized businesses, as well as large enterprises worldwide. Cloud computing stocks have been huge winners in 2010 because the technology is seen as a huge cost reducer and time saver for individuals and corporations.

    Basically, cloud computing does offers users the ability to store their data or applications on servers they don’t own instead of individual computers. With cloud computing, all a user needs is an Internet connection and a working computer to access his or her applications and data. This cuts costs in a big way because public and private companies that use cloud computing don’t need to hire as many computer technicians or software administrators to monitor their networks. Plus, they don’t need to own as many servers or spend a lot of money on security applications because all of those costs and services are done by the cloud computing companies.

    Rackspace specializes in Web hosting services such as dedicated servers that host clients’ Web sites and e-mail servers, store important data and provide access to software applications to employees’ desktops at anytime. As companies in this new digital era need more and more bandwidth, security, storage and operational scale, they’ll turn toward Rackspace to help them manage those needs. The company currently has over 99,000 customers, including over 80,000 cloud computing customers.

    Rackspace just made a key acquisition of a company called CloudKick, which makes web applications that control cloud-server management. CloudKick specializes in helping developers and system administrators deploy and manage their cloud environments. I expect this acquisition – and many more to come in the future – to help Rackspace continue to growth its quarterly revenues by over 20% if not higher.
    This looks to be another case of the bears shorting a stock on valuation. Rackspace currently trades at a trailing price-to-earnings of around 99 and forward-price-to-earnings of 59. That’s no doubt a loft valuation, but if Rackspace can continue to grow quarterly earnings by over 20% and expand rapidly into international markets and with key acquisitions, then this stock is far from expensive.

    Basically what I am saying is that the stock might look expensive now, but the bears are betting that the company’s high-growth days are over. Do you really think that’s a smart bet when we’re so early into the entire market shift towards cloud computing? I just don’t agree with the bear case here.

    The current short interest as a percentage of the float for Rackspace stands at a whopping 27%. That is definitely one gigantic short position by the bears. If the bears turn out to be wrong, and I believe they will, then this stock has a long way to go on the upside.

    Keep in mind that right now Rackspace is trading near all-time highs at around $31 a share. That means that anyone who has shorted this stock is losing money and is already on the wrong side of the trade. Just imagine if the bears wake up one day and this company gets taken over by some tech heavyweight that wants to get in on the cloud computing trend. That alone would probably produce a massive short squeeze for the record books.

    To see more heavily shorted stocks that could experience massive short squeezes, including Sears Holdings (SHLD), Travelzoo (TZOO) and Portfolio Recovery Associates (PRAA), check out the Heavily Shorted Stock 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.