Squeeze the Shorts

How do you outsmart the smart guys? One way is to buy the stocks they’ve ganged up on and sold short. And what’s a cheap way to buy stocks? Use options to leverage a large play.

The smart guys think they can sell stocks short, watch them fall and pick them up later at bargain prices, pocketing the difference. But short sellers often bet wrong. If the stock rises they must go into the market and buy it back, causing the price to jump higher. This is a “short squeeze” and options trading investors can profit from the jump.

The trick is to find the stock before it jumps and buy call options to leverage this move. That’s what we do in our Winning Edge service.

We selected six stocks using a filter that finds strong stocks with short-interest ratios (number of shorted shares divided by average daily volume) of at least 7.0 (e.g., it would take at least seven days to cover all shorts). Our list includes Moody’s (NYSE: MCO), Crocs (NASDAQ: CROX), and Simon Property Group (NYSE: SPG).

Crocs (NASDAQ: CROX)

The specialty footwear maker is hot right now. In fact, the shares hit a three-year high this week, thanks in part to its Chameleons (they change color in the sun!) line, which is selling so fast the company may run out of them. That’s a nice problem to have.

With the stock up nearly 40% this year, you’d think sentiment would be positive. But the short-interest ratio is climbing (it now stands at 7.3) and the put/call ratio is coming off a peak, a sign of unwinding pessimism that usually means more buying pressure is on the way. And analyst coverage is minimal so the shares should get a boost from new ratings.

A stock making new highs with hot products and lots of pessimism is a bullish combination in our book. Let’s give the equity plenty of time to let the short interest unwind. Buy the CROX September 24 Call for $2.50 or less.

Cintas (NASDAQ: CTAS)

This corporate uniform supplier has been blowing the broader market away for more than three months. That period included another solid earnings report in which the company beat the consensus estimate by 14%.

Since the end of February, the stock is up 14% while the SPX is down 4%. But the shorts (short-interest ratio of 7.1) and analysts (just three of 12 rate the stock a “buy”) continue to bet against the shares. That tells us there’s plenty of buying power waiting to come in off the sidelines.

Buy the CTAS August 30 Call for $3.00 or less.

Moody’s (NYSE: MCO)

Credit research and rating provider MCO was hit with a downgrade this week thanks to the Greek credit contagion. The drop pulled the shares down to their 50-day moving average, a trend line the shares have closed below just twice this year.

Prior to the downgrade, MCO was a huge performer, adding more than 55% in 2011 alone after hitting a multi-year high last week. Yet short interest remained high with a short-interest ratio approaching 9.0. With low analyst coverage, MCO is primed for another leg higher as this pessimism unwinds.

The cooling off this week offers us an excellent entry point for a call trade. With the “Greek effect” priced into the shares and the froth blown off the stock, MCO looks poised to resume its monster uptrend that began about a year ago.

Buy the MCO August 38 Call for $2.60 or less.

Simon Property Group (NYSE: SPG)

This real estate investment trust invests primarily in malls, outlet centers, and premium properties. The company has been an earnings monster, having missed just one estimate in the past 15 quarters.

The stock has pulled back amid the recent market weakness, dropping about 5% from a four-year high reached at the end of last month. But the shares have stabilized above the key 110 level and are hanging onto the support of the 50-day moving average.

Sentiment toward SPG is largely negative, even though the commercial real estate market has shown signs of life for several months. The put/call ratio is peaking at an annual high and the short-interest ratio is above 8.0. That means lots of pessimism waiting to unwind.

Buy the SPG October 115 Call for around five bucks.

Veeco Instruments (NASDAQ: VECO)

VECO is in the semiconductor equipment space, providing systems used to make LEDs, solar panels, hard disk drives, and other devices. The company hasn’t missed an earnings estimate in nearly four years, including a 12-cent beat in April that was followed by a 7.5% surge in the following week.

The stock has been stair-stepping higher since last August, using the combined support of its 50-day and 100-day moving averages to advance more than 70%. The stock is now stabilizing along the solid support of its 50-day after pulling back from a 10-year high reached last month.

Despite its success on the charts, pessimism is largely negative. The put/call ratio is declining from a peak (a bullish sign of more buying) and only nine of 16 analysts rate the stock a “buy.” And short interest is nearly off the charts, with almost a third of the float sold short.

With so much pessimism on a stock with strong technical support, we like VECO over the intermediate term. Buy the VECO October 50 Call for around seven bucks.

Becton, Dickinson and Company (NYSE: BDX)

This medical instrument and supply company is considered a solid defensive play for today’s market. The company’s latest earnings report was strong and included raised EPS guidance for 2011. The company also has a history of steadily raising its dividend.

The stock has been treading water around the 85 level throughout most of June. This level defined BDX highs in December and February, so the support we’re seeing is hardly surprising. The 50-day moving average is also in play as support.

Sentiment toward BDX is mixed. On the one hand, the put/call ratio is low. On the other hand, the short-interest-ratio has been rising for four months and only a third of covering analysts rate the stock a “buy.”

BDX is not an exciting play. But that’s what defensive stocks are all about. With solid technical support, some immunity from economic conditions, and plenty of pessimism waiting to unwind, we see BDX as a solid, if mundane, play for the rest of the year.

Buy the BDX December 85 Call for five bucks or less.