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In this article, I would like to bring forward a trading argument that might pay off very profitably in case we experience a market swoon in May and June of this year. I would argue that very heavily shorted stocks (stocks with a high percentage of their float shorted) will prove to be the most resilient -- and even profitable -- in a market sell-off. I should disclose that I expect a short relief rally before the start of a major correction in late May. The trading suggestions associated with that relief rally are analyzed in a separate article ("5 Excellent Quick Trades Until May 17"). Therefore, the trading suggestions in this article should be initiated toward late May.

Many portfolio managers make it their overall strategy to invest in whatever is popular and sell short whatever is beaten down. By following the herd, they can pass the blame on to a change in market conditions if things don't work out. Such trades are usually also done in pairs in order to make the portfolios market neutral. Of course, without matching the risk characteristics of specific stocks, the portfolios are definitely not market neutral. However, let's assume they are for the purposes of this article.

What happens in a market swoon?

Major market corrections are usually an event of decreased market liquidity rather than deteriorating fundamentals. Portfolio managers are forced to close their positions altogether, rather than evaluating those positions on fundamental reasons. They basically get out of the market irrespective of the stock-specific issues.

Why would this cause an increase in the price of heavily shorted stocks?

It should be noted that portfolio managers close their positions in a market swoon; they don't usually try to increase their shorts to take advantage of the falloff in the markets. Just as the unwinding of long positions pushes down the price of high-flying popular stocks, the unwinding of the short positions in the heavily shorted stocks results in a short squeeze and pushes up the price of those heavily shorted stocks.

What are the advantages of this trading strategy?

This is a good way to invest in stocks for investors who don't feel comfortable shorting stocks, but who want to protect themselves in case of a market correction in early summer 2012. For investors who are willing to hold short positions, this is also a great way to arbitrage the valuation discrepancies between high-flying popular stocks and the stocks of good companies that trade at unfairly low valuations. By shorting the popular, richly valued stocks and going long the undervalued ones, investors can also partially offset the market risk in a portfolio. As mentioned above, due to mismatches in the risk profile of different stocks, it is almost impossible to achieve a truly market neutral portfolio. However, it is possible to offset some of the market risk by pairing the long and short positions.

What are possible stocks to go long?

My favorite picks that are heavily shorted and due for a short squeeze if the above theory holds are KB Home (NYSE:KBH), LDK Solar (NYSE:LDK), Sears (NASDAQ:SHLD), Rubicon Technologies (NASDAQ:RBCN), Arch Coal (NYSE:ACI), Alpha Natural Resources (NYSE:ANR), Saks (NYSE:SKS), Barnes & Noble (NYSE:BKS), Veeco Instruments (NASDAQ:VECO), and Cree (NASDAQ:CREE).

What are possible stocks to short in order to decrease the market risk?

The stocks that will get hit the hardest by a turn in market sentiment are the cloud technology companies, in my opinion. Some of these stocks have even withstood the hit that the Nasdaq took while Apple (NASDAQ:AAPL) was shaky. However, should the market enter a major correction in May and June, that might be prove to be the excuse to finally knock these high-flying, absurdly valued companies back down to more reasonable valuations. I would suggest shorting Salesforce (NYSE:CRM), F5 Networks (NASDAQ:FFIV), NetSuite (NYSE:N), TerraData (NYSE:TDC), RedHat (NYSE:RHT), and Apple. The last suggestion is obviously due not to overvaluation, but because the stock is way too popular and would be hit hard by a turn in market sentiment.

Source: Why Heavily Shorted Stocks Might Rise In A Market Swoon