Short covering, also called “buying to cover”, refers to the purchase of securities by an investor to close a short position in the stock market. The process is closely related to short selling. In fact, short covering is part of short selling, which involves the risky practice of borrowing and selling stocks in the hope of buying them back at a lower price, thus generating profits.
What is Short Positioning?
In short selling, investors hold a belief that the price of the stock will fall. The practice is also known as short positioning.
Short Positioning Cycle
Opportunity – An investor sees an opportunity that the price of a given stock in the market will soon fall.
Opens short position – An investor borrows the shares of the company at the current price.
Selling the stocks – The investor sells the borrowed shares. This is selling short.
Waiting period – The incubation period in which the investor must wait for the stock prices to drop before closing a short position.
Closing a short position – Once the stock price drops, the investor buys back the exact number of shares borrowed.
Revenues – In the previous phase, there are two things happening in the market. One, the stock prices may fall as anticipated. The outcome will naturally lead to profits since the trader will exit the short position lower. The difference between the entry and exit is the profit. However, should the stock price rise, the trader will incur a loss since he must pay a higher price to buy the stocks back.
Example: Short Covering
Let’s take the example of Joe, a savvy equity trader. He’s been in the stock trade long enough to understand the way the stock market works. Recently, he’s been tracking the stock performance of XYZ Company. According to his research and trading experience, the stock of XYZ is likely to fall soon. Joe borrows 1,000 shares to open a short position with the stock trading at $30. He sells them at the current market price of $30.The price hits what he anticipated, $20 per share. So, he buys the 1,000 shares at a current price of $20 to close the short position. According to the math, Joe will generate a revenue of $10,000 ($30,000 – $20,000). He sold his borrowed stocks at $30,000 (1,000 shares x $30) and bought them at $20,000 (1,000 shares x $20,000).
Price Increases in Short Positioning
During short positioning, the price of a stock can rise or fall. If it falls, traders make profits, which is precisely what they want. However, if it increases, they are on the verge of incurring losses. As a result, they may rush to opt out of the short position by buying back the stock. However, the more they buy, the more the stock price rises. This leads to what is known as a short covering rally.
Short Covering vs. Short Squeezing
In short squeezing, the prices of the security rise significantly leading to a situation where traders rush to close their short positions due to the pressure of increasing stock prices.
Example: Short Squeeze
Using Joe’s investment, let’s assume that after the first month, stock prices start moving in the opposite direction. Instead of the price going down, it starts rising by 12% per day. Joe and other traders will rush to close their short position before they incur more losses. So, they will be squeezed out of the trade.
Short covering is the means by which traders holding a short position in the stock market close out their trade. It is the buy transaction that closes out their initial sell transaction.
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