What Is Short Covering?
The practice of purchasing back borrowed assets to finish an open short position and realize a gain or a loss is referred to as "short covering." It entails acquiring the identical asset sold short and returning the shares initially acquired for the short sale. In addition, the short seller must buy back the shares that were initially sold short. The term "purchase to cover" refers to this business transaction.
For instance, a trader believes that the price of XYZ shares will continue to fall, so they sell 100 shares short of the company for $20 a share. After XYZ dropped below $15, the trader bought more shares to cover the short position and recorded a profit of $500 from selling the asset.
Main Points
By placing purchases to cover orders, shorts may buy back shares they borrowed to sell short, thereby closing off their short position.
The outcome of short covering may be either profitable or unprofitable, depending on whether or not the asset is repurchased at a lower price than the price at which it was sold (if it is higher).
If there is a short squeeze and sellers become susceptible to margin calls, then the market may require short covering. The likelihood of a squeeze may be forecasted using several indicators of short interest.
How Does Short Covering Work?
Liquating an open short position is impossible without first engaging in short covering. If the short position is covered at a lower price than the original transaction, the trade is lucrative; if the retail value exceeds the initial transaction, the trade is unprofitable. When there is a significant amount of short covering taking place in security, it can lead to a situation known as a short squeeze. This situation is where short sellers are pressured to liquidate their positions at ever-increasing prices because they are losing money and their brokers are invoking margin calls.
The unconscious short covering may also occur when a company with significant outstanding short positions is subjected to a "buy-in." A broker-dealer will "cover" a short position if the stock is no longer lendable and the broker-dealer cannot sell the shares. Typically, this occurs in equities with a lower trading volume and a smaller number of stockholders.
Things to keep in mind
Short Interest and Short Interest Ratio (SIR)
When the number of short holdings and the short interest ratio (SIR) are both high, there is a greater possibility that short covering may be unorganized. An early part of a rebound after a bear market or a sustained loss in a stock or other investment is often caused by short covering. Because of the potential for their losses to snowball out of control during an extended rise, short sellers often maintain their holdings for a shorter amount of time than investors who keep long positions. Consequently, short sellers are often very fast to cover short sales whenever there are indications that market sentiment is shifting or when the fortunes of security are deteriorating.
Example of Short Covering
Note that XYZ has 50 million shares available for purchase, 10 million shares sold short, and 1 million shares traded on average each trading day. The SIR for XYZ is 10, and short interest is at 20%; thus, these numbers are quite high for the stock (suggesting that short covering could be difficult).
Over many days or weeks, XYZ gradually loses ground, encouraging an even higher level of short selling. They make the announcement one morning just before they open. It is a huge customer that will significantly raise their quarterly profits. When the opening bell rings, XYZ jumps higher, cutting into the gains of short sellers or adding to their losses. While some short sellers are looking to cover their positions as soon as possible, others are trying to get out of their holdings as quickly as possible in the hopes of getting a better price. As a result of this uncontrolled short covering, XYZ continues to rise in a positive feedback cycle until the short squeeze is exhausted. At this point, the short sellers hoping for a favourable reversal suffer even greater losses.
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