What is Short Covering?
Short covering refers to buying of already sold security which is borrowed in anticipation of a fall in price to cover the short position. A Short position is created by short-selling or selling of security which is initially borrowed with the expectation of buying at a lower price.
Short covering is related to short selling. We must first understand how short selling works, and why would one undertake such a strategy? Short sellingShort SellingShort Selling is a trading strategy designed to make quick gains by speculating on the falling prices of financial security. It is done by borrowing the security from a broker and selling it in the market and thereafter repurchasing the security once the prices have fallen. is generally undertaken by an investor if he has a pessimist view on the underlying security or expects it to fall so that he could make a profit by buying it again at a lower price.
- So the first step in the process is borrowing the security to sell it. The lender of the security charges a fee for lending its security to the short seller.
- The short seller then sells the security in the market in the hope that the price would fall, and he would buy it at a lower price and deliver it to the secured lender.
- The short seller waits for the security price to fall. When the price drops, he buys exactly the same number of the share he borrowed and sold. This step of buying back the security is called short covering as it closes the position undertaken by him. The profit is the difference between the price at the time which he borrowed and the price at which he bought back the share.
- In case of price rises, then the short seller incurs losses as he must buy at a higher price than at what he sold and deliver the security to the lender.
Example of Short Covering
- Consider that stock of a company ABC ltd. is trading at $55, and a speculator expects a fall in it. He then borrows the stock from the investor already holding that stock at some predetermined interest rate. The speculator would then short that stock into the market and wait for the price to fall. Suppose the price falls to $52, the short seller would then short cover by buying ABC ltd. At $52, he would buy ABC ltd. and deliver it to the investor who lent it to him. Thus the profit made by short-seller is $55 – $52 =$3 (excluding commission and interest payment)
- It implies that the stock price is expected to rise. Sometimes short-covering leads to an increase in the rise of the underlying assetsUnderlying AssetsUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. as it involves buying of stock. Initially, when a few short positionsShort PositionsA short position is a practice where the investors sell stocks that they don't own at the time of selling; the investors do so by borrowing the shares from some other investors to promise that the former will return the stocks to the latter on a later date. are covered, a slight increase in the price may happen. Seeing the slight increase in price, some short sellers may get nervous, and they might start short-covering, leading to more buying and a rise in the price of stocks.
- This sudden panic leading to buying of stock after an increase in stock price and causing a significant rise in price is called a short squeezeShort SqueezeShort squeeze refers to the situation that arises when there is an unexpected increase in stock price, adversely impacting the short-sellers, who are then forced to buy the stocks at a higher price to cover their short position and results in a further increase in the stock price.. This buying leads to more short covering by short sellers to close their short positions before incurring more losses. This causes a rush towards buying, which makes stock price move sharply in an upward direction.
- For instance, if the stock of ABC ltd. that short-seller sold at $55 rises to $56 due to some favorable news, some short-sellers would go for short-covering, which will drive the price higher to $57. This rise will create a rush among short-sellers to cover and buy the stock of ABC ltd. to prevent themselves from more losses.
Short Cover vs. Short Squeeze
- The Short cover basically is to close the already open short position by buying the stock from the market. At the same time, the short squeeze involves huge buying by short sellers because of the sharp rise in the price of the stock. The increase in the price pushes the short seller to close their short position and book losses. This buying of stocks lead to further increase in stock prices which pushes more short seller to close their short positions leading to a higher price of the stock.
- A short squeeze may happen due to several reasons. Sometimes short-covering by short-sellers leads to a rise in prices, which further leads to a rush towards buying and a significant increase in price that causes short squeeze. Another reason could be some unexpected favorable news that may result in a sharp rise in prices of a stock.
- For instance, suppose in the above example, speculator shorts ABC ltd. for $55 because of some news claiming financial irregularities in the company and as a result price drops to $50. But soon, the claim was found to be frivolous due to which stock recovered instantly to $56 that led to covering by short sellers to avoid losses causing the short squeeze.
Short covering is necessary to close the open position. A short sell position is held for a brief period of time, and short-covering depends on the movement in stock price. The intense short-covering may increase the price of the stock and eat up the profit of short-sellers. Given the dynamics and volatility, short selling and thereby, they are very risky strategies that may result in huge gain and loss.
This has been a guide to what Short Covering is and its definition. Here we discuss the example and difference between Short Cover and short squeeze with a detailed explanation. You can learn more about financing from the following articles –