I am by nature a seller and always on the lookout for opportunities arising from stocks falling in value. That’s why I keep an eye out for possible short squeezes where a stock may jump suddenly in value. Right now I see opportunity for options trading investors in Diamond Foods (NASDAQ: DMND) and 99 Cents Only Stores (NYSE: NDN).
A short squeeze occurs when “shorts” — traders who have borrowed shares, dumped them and need to buy them back to “cover” their loan — go to market at the same time to buy the shares. This pushes the stock sharply higher.
Options traders seeking to take advantage of this should look for a fundamentally sound stock with an overly large short position. The idea is to buy calls before the short sellers have to buy back their shares.
Diamond Foods (NASDAQ: DMND) is heavily shorted, with more than 30% of the shares held short and with a “days to cover” ratio of more than 30 days. Days to cover is an indicator that divides the average daily trading volume into the number of shares held short. This stat provides a sense of how long it would take for all short positions to be liquidated. Thirty days is a big number.
DMND has a rich trailing P/E of 45 and traders believe commodity prices will wreck the company. I think during a recession people giving up big things but buy more little things — like the packaged nuts and snack products that DMND sells — and the shorts have it wrong. Diamond’s quarterly results were released yesterday and were stronger than analysts expected. Earnings came in at 52 cents a share, topping the consensus by 4 cents, and revenues rose nearly 61% compared with the same period a year ago.
Recognize that DMND is a high risk options trade. Think about short-term calls that are out of the money.
Find more option analysis and trading ideas at Options Trading Strategies.
If you want something less risky and longer term, 99 Cents Only Stores (NYSE: NDN) just released earnings and this heavily shorted stock did not move that much as the earnings were not a real surprise. The theory behind a short position is high gasoline prices hurt shoppers at these super discount stores harder than other retailers. My belief is the company is well managed and it will easily ride out a slowdown in revenue growth, which was 6% in Q1. About 15% of the float is held short, and days to cover is about 15 as well. This lack of movement after earnings means to me the Street will slowly unwind these short positions. I would look at a longer term strategy — either sell out-of-the-money puts or buy out-of-the-money calls that expire in the fall. The shorts will keep the price up or push it up higher as they slowly close their positions.
Michael Shulman uses simple trading tactics to make solid, profitable investments in falling stocks in his Short-Side Trader service.