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Being a contrarian and playing a heavily shorted stock can, in some situations, lead to a ” short squeeze” and thus be one of the most profitable ways to make money in the markets. A “short squeeze” occurs when short-sellers rush to cover their positions due to a rapid increase in the price of a stock or futures contract. Such an event generally occurs in stocks that have small floats and a large number of short positions (relative to the float).

A “short squeeze” can be caused by any number of different reasons – generally speaking, the most common cause is an unexpected piece of good news for a company. This leads to people taking new positions in the company’s stock, the price rising and short-sellers deciding that they want to get out of the stock. The short-covering only adds fuel to the fire, sending the shares even higher.

Both ATP Oil & Gas (ATPG) and First Bancorp (NYSE:FBP) have been the subjects of heavy shorting, some of which has been reported as naked-shorting, and may be finally ripe for a short squeeze due to the improving fundamental and technical aspects.

First Bancorp:

After being down more than 82% year-to-date, from a 52-week high of $3.84 down to a 52-week low of $0.24, shares of First Bancorp have begun to rally on news that CEO Aurelio Alemá and the company's board of directors rejected a recent buyout offer of $0.30 a share from Doral Financial Corporation (NYSE:DRL). Whispers on Wall Street strongly indicate that other offers could be put forth at much higher premiums.

This, however, was not the first instance where a larger financial corporation made an offer to buy a smaller one in order to capitalize on the cheap valuations and expand operations. A few days ago, on December 17, Bank of Montreal (NYSE:BMO) had agreed to a deal to buy Marshall & Ilsley (NYSE:MI), thus opening the door for a previously unseen catalyst to affect small banks in a positive manner. Many analysts believe that BMO’s deal to buy Marshall & Ilsley is likely one of many to come.

Bank of Montreal, Canada’s fourth-biggest bank by assets, agreed to buy Wisconsin’s Marshall & Ilsley Corp. for $4.1 billion to expand in the U.S. The deal values Marshall & Ilsley at $7.75 a share, compared with Wednesday’s closing price of $5.79 on the New York Stock Exchange, Toronto-based BMO said in a statement on Thursday.

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With well over 45% of the float being in the hands of the short sellers, it is clear that not many believe in the future of this bank, yet it is exactly these situations that usually represent the most opportunities for investors looking to make multi-bagger gains.

On the chart above we see that a mini cup and handle pattern has formed over the last two months, with a breakout that could pop the stock to around $0.50 a share. Considering this is an estimate not taking into account the possibility of a short-squeeze, it would not be surprising to see a strong push towards the $0.70 resistance last seen in early August.

As seen by the recent moves on Wednesday's trading session in CCF Holding Company (OTCQB:CCFH), which is up 16.67%; BankAtlantic Bancorp (NYSE:BBX), up 22.86%; and Oriental Financial Group (NYSE:OFG), up 4.16%, small banks are clearly becoming popular among traders seeking high returns.

ATP Oil & Gas Corporation:

More recently, on Wednesday's trading session, the price of crude oil futures in the United States rose to a two-year high on Thursday after it passed $90 per barrel. The rising price came after information was recently released indicating that gasoline and crude stockpiles decreased the previous week. According to the American Petroleum Institute’s report, which was released in the evening hours of Tuesday, crude oil stock declined 5.8 million barrels since the previous week while gasoline stockpiles dropped 2.9 million barrels.

As the demand for gasoline continues to rise during the holiday season and supplies drop, the price of gasoline is expected to increase in the next week. It is possible (but not likely) to see the price of oil reach $100 per barrel in 2011.

How can you justify having a healthy portfolio without holding some sort of energy company? The reality is, you can`t.

ATP Oil & Gas is a company that is down 14% year-to-date, yet the 36% shares short of the total float could offer a nice bonus to shareholders once some positive news comes rolling in -- and this may not be too far off, given its recent announcement of a quarterly cash dividend. That dividend is on its 8.0% Cumulative Convertible Perpetual Preferred Stock at a rate of $2.02 per share, and is payable on January 3, 2011 to shareholders of record at the close of business on December 15, 2010. It is general investment knowledge that a company declares a dividend as it begins to rebound and move towards a more positive future outlook. Many believe it is this company that will benefit most from the recent moratorium lift, and not BP Global (NYSE:BP).

From Investment Underground (here):

ATPG engages in off-shore drilling and production at proven, but not-yet-developed, fields in the Gulf of Mexico and in the North Sea. So far, the company has carved itself a profitable niche, drilling with a 98% success rate and avoiding the “wildcat” risks of targeting and then drilling exploratory wells.

The company operates three subsea wells in the North Sea, with its key operation at the Cheviot field coming online in 2012.

From a technical perspective, it is easy to see why a short squeeze could erupt at any given time. The stock recently broke out of a three-month long ascending triangle pattern, and is now on the verge of breaking out of a bullish wedge formation.

Perhaps more noticeable is the 50-day moving average crossing the 200-day moving average and forming a golden cross, thus signalling that the long-term uptrend looks to continue. Buyers have definitely begun to step in and put pressure on the short sellers, as seen by the Relative Strength Index (RSI) metric, which has now broken out of a three-month-long downtrend. A bullish cross has also taken place on the full stochastic, further validating a corrective move to the upside in the near future.

Options were also heavily traded on the stock for the January 21 expiration, wtih the $17.50 and $16.00 strike price call options being at the top of the list. A total of 1,701 were traded, with 7,096 on the open interest side for the $17.50. Doubling that were the $17.50 strike price call options with a volume of 3,495 and 4,219 open interest, signaling that many investors purchased the calls at market price as they strongly believe it will reach at or near the strike price before the expiration date.

Disclosure: I am long ATPG, FBP.

Source: Two Companies Bound for Short Squeezes: ATP Oil & Gas and First Bancorp