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.
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