Is Coinstar Inc. (CSTR) Ripe for a Short Squeeze?

Coinstar Inc. (NASDAQ:CSTR) is one of the most heavily shorted stocks on the Nasdaq. Is the company ripe for a short squeeze? If shorts are forced to cover their bets against Coinstar, the stock could experience a powerful move higher.

Coinstar is heavily shorted

Unfortunately, short interest is not available in real-time; rather, it is reported bi-monthly. That said, as of the last report, shares of Coinstar inc. (NASDAQ:CSTR) are heavily shorted — over 50% of the company’s outstanding shares have been sold short.

Why have short sellers taken such an interest in the company? Famed short seller Jim Chanos may have started the trend. Last April, Chanos told CNBC his fund had begun betting against the company on the grounds that technological shifts were rendering its product obsolete (consumers were increasingly getting movies through digital downloading services, rather than renting physical discs).

After Chanos made those remarks, short interest steadily began to grow — from about 8 million shares March 2012 to a current short float of over 14 million shares.

Short squeezes can send stocks to new highs

Stocks that are heavily shorted have the tendency to undergo significant moves. Any good news can cause shorts to cover their bets — buying stock in the market and driving up the price. As the price rises, other short sellers (weary of losing money) cover their bets, in turn sending prices higher still.

This short squeeze tendency can have a tremendous effect on stocks. Take Netflix Inc. (NASDAQ:NFLX).

Shares of Netflix rallied about 60% in a very short period of time. On Dec. 31, over 13 million shares of Netflix had been bet against. By the middle of February, that figure had plummeted to about 8 million shares.

On Jan. 23, Netflix reported a profit of about $8 million. Wall Street had been expecting the company to post a loss of a similar amount. That single $8 million profit, in the subsequent sessions, added about $4 billion to the company’s market capitalization as shares went from trading near $100 to trading well over $160.

Were investors, so stunned by a $30 million profit, eager enough to rush out and buy shares? It’s certainly possible, but a more probable explanation may have been short sellers rushing out to cover their losing bets.

Pandora Media Inc (NYSE:P) is a more recent example of a short squeeze

Internet radio giant Pandora Media Inc. reported earnings March 7. In the subsequent trading session, shares gained over 20%. Again, like Netflix, it’s entirely possible that investors were so moved by Pandora’s surprising earnings results that they rushed out en masse to buy stock. But there seems to be a more likely explanation.

According to the last report on Feb. 28, over 38 million shares of Pandora had been sold short. That represents about one-fourth of the company’s outstanding shares. When the next report of short interest is released, investors should check Pandora. It is likely that the short interest will have dropped significantly.

Like Netflix, the recipe for higher profits was relatively simply. The company had been bet heavily against, earnings were better than expected, and shares experienced a magnified rally.

Skullcandy Inc. (NASDAQ:SKUL): the short squeeze that wasn’t

In the interest of full disclosure, it’s worth pointing out a counter-example: Skullcandy Inc. (NASDAQ:SKUL).

Shares of Skullcandy were heavily shorted heading into the headphone makers last earnings report. Coincidentally enough, that happened to fall on the same day as Pandora’s report, March 7. But in the after-hours session that day, shares headed in opposite directions.

While Pandora traded up some 20%, Skullcandy tanked, dropping a roughly equal amount (a long Pandora, short Skullcandy pair trade would’ve returned about 40% over a single session). Skullcandy was even more heavily shorted than Pandora, but unfortunately for Skullcandy, its earnings were terrible.

In fact, the company’s earnings were so bad that it may have emboldened short sellers in their trade. Given the high risks short selling brings, traders often enter their positions slowly, increasing the size of their short bet over time. A bad report from a company they are already bearish on can lead to a bigger bearish bet.

What should investors do with Coinstar?

On the risk-reward continuum, going long Coinstar inc. (NASDAQ:CSTR) via out-of-the-money call options might not be a bad trade. A hint of good news could trigger a short squeeze given that over half the shares have been sold short.

In fact, short sellers themselves reflecting on the higher short interest might be apt to start scaling back their bets, knowing that the risk of a powerful short squeeze is magnified with a short interest so high.

Of course, every trade brings risks. If the bears are right, and Coinstar inc. (NASDAQ:CSTR) is headed for trouble, a bad report, like with Skullcandy, could decimate shares. In fact, I wrote that Coinstar could be bankrupt in five years.

But a bullish contrarian trade, using a small amount of capital and on a short-term basis, could reap immense rewards.

The article Is Coinstar Ripe for a Short Squeeze? originally appeared on Fool.com and is written by Salvatore “Sam” Mattera.

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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