Stock Quotes in this Article: ATU, CPST, MCZ

WINDERMERE, Fla. (Stockpickr) -- News events have the power to create massive volatility in stocks, and the one event that can move them substantially higher or lower is an earnings release. Take that one step further and combine a bullish earnings report with a stock that’s heavily shorted, and you have the fuel that can ignite a large short squeeze.

Short-sellers hate being caught short a stock that produces earnings that please the bulls on Wall Street. When this happens, tradable short squeezes often develop as the bears rush to cover their positions and avoid even bigger losses. Even the best short-sellers know that it’s never a good idea to stay short once a big earnings-sparked short-covering rally starts.

This is precisely why I search the market for heavily shorted stocks that are about to report earnings. You only need to find a couple of these candidates in a year to help enhance your portfolio returns – the gains become so outsized in such a short timeframe that your profits add up quickly.

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    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 from off a short squeeze. When you do this, you’re letting the trend emerge after the market has digested all of the news.

    That said, sometimes a stock will be in such high demand that you could miss a lot of the move. That’s why it’s only worth betting prior to the report if you have a very strong conviction that the stock is going to explode higher.

    Here’s a look at a number of stocks that could experience big short squeezes when they report earnings this week.

    Mad Catz Interactive

    My first earnings short squeeze candidate is Mad Catz Interactive (MCZ), which is set to report its results on Tuesday after the market close. This company designs, manufactures, markets, sells and distributes accessories for all videogame platforms, the personal computer and the iPod and other audio devices. There are currently no analyst estimates available for Mad Catz for this quarter.

    I think Mad Catz has a good chance of beating estimates after video game maker Majesco Entertainment (COOL) just raised its fiscal 2011 guidance for net revenue to a range of $110 to $120 million, up from the prior range of $100 to $110. If video game makers such as Majesco see business picking up, then it should mean sales will also jump for Mad Catz, whose products are complementary to games.

    From a technical standpoint, shares of Mad Catz are currently trading below the stock's 50-day and 200-day moving averages. The stock has also been making lower highs since April when shares hit a yearly high of $2.39 a share. I wouldn’t get too excited about going long this stock until it's back above its 50-day moving average of $1.87.

    One could play this stock ahead of or after earnings if you see shares break above $1.87 on strong volume. Look for volume that’s well above its three-month average action of 1.9 million shares. I would add to the position aggressively if you see $2.00 a share breached to the upside. Keep in mind that $2.39 would be the breakout price as well, and any move above that level should be considered very bullish.

    I recently featured Mad Catz in a list of Zynga IPO Stock Plays.

    Capstone Turbine

    My next earnings short squeeze play is Capstone Turbine (CPST), which is set to report its results on Tuesday after the market close. This company develops, manufactures, markets and services turbine generator sets and related parts for use in stationary distributed power generation applications. Wall Street analysts, on average, expect Capstone to report revenue of $25.97 million on an earnings loss of 3 cents per share.

    According to an FBR Capital Markets analyst, Capstone Turbine is on the verge of moving into a higher growth mode. The analyst recently gave the stock an outperform rating and said that the company’s transition will be helped as the adoption of microturbine technology increases globally. The analyst also sees potential for marquee orders in the global oil and gas markets in the U.S., Russia, Latin America and Australia.

    The current short interest as a percentage of the float for Capstone is a very large 17.5%. That means that out of the 208.47 million shares in the tradable float, 42.56 million are sold short by the bears. The short-sellers have been increasing their bets on Capstone from the last reporting period by 4.2%, or by about 1,.7 million shares.

    From a technical standpoint, shares of Capstone are currently trading below both the 50-day and 200-day moving averages. This stock has also been making lower highs since late March. That said, shares have found some buying support at $1.52 to $1.53 a share, which is a previous support level from back in early March.

    One could be a buyer of this stock ahead of the quarter and simply stop out if it drops below $1.52 a share. I would only buy once you see shares move back above the 50-day moving average of $1.79 on strong volume. Look for volume that’s well above the three-month average action of 4.2 million shares. Keep in mind that the breakout price would be $2.14 a share for Capstone. Any move above that price following earnings should be considered very bullish.

    Capstone shows up on a recent list of 10 Stocks Under $3 With Upside.

    Actuant

    Another heavily shorted stock that could be setting up for a squeeze is industrial products and systems manufacturer Actuant (ATU), which is set to release its numbers on Thursday before the market opens. Wall Street analysts, on average, expect Actuant to report revenue of $379.09 million on earnings of 46 cents per share.

    During last quarter, the company fell in line with estimates after beating Wall Street forecasts in the prior two quarters. If Actuant, trading at a reasonable forward price-to-earnings of 12, can get back on track and beat estimates for this quarter, the stock could take off.

    The current short interest as a percentage of the float for Actuant is a rather large 14%. That means that out of the 63.12 million shares in the tradable float, 8.8 million are sold short by the bears. The shorts have also been increasing their bets from the last reporting period by around 3.5%, or by about 300,000 shares.

    From a technical standpoint, shares of Actuant have been crushed since late February, dropping from its yearly high of $30.41 to its recent low of $22.50 a share. One could be a buyer of this stock following the report as long as it doesn’t drop below that recent low of $22.50. Look for some strong upside volume to move into the name that’s greater than the three-month average volume of 724,000 shares.

    Keep in mind that $22.50 is a big previous support level that dates back to November 2010. That means this is either a great buying opportunity on Actuant, or it’s going to break support and head much lower. Use that price point as your guide to how to trade this one following earnings.

    Actuant was highlighted Monday in "5 Earnings Stock Trades for Quick Gains."

    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.