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 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.

• Short covering refers to closing out a short position in security by buying back the shares or assets that were borrowed and sold short.
• Short covering often occurs when traders or investors who have taken short positions anticipate a potential increase in the security price. They buy back the shares to limit potential losses or lock in profits as the price rises, creating upward pressure on the security's price.
• Short covering can significantly impact market dynamics, particularly during periods of high short interest. As short sellers rush to cover their positions, increased buying activity can lead to a short squeeze, where the upward pressure on the price is intensified, potentially triggering further price increases.
• Short covering can provide insights into market sentiment and the perceived direction of a security's 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 selling 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.
• During short covering in stock market, 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.

Let us look at the following Deepak Nitrite Limited chart to understand the concept better. 

Source

In the above hourly chart, one can observe Deepak Nitrite futures broke out of the trading range and ascending triangle and the price continued to move in the direction prevailing prior to the triangle. With the drop in the open interest before the expiration, there’s an indication of short covering. Accordingly, one must consider trading with a specific target and stop-loss.  

If individuals wish to improve their knowledge with regard to short covering, they may look at similar charts that are already published on the TradingView platform.  

There are some pointers or indicators that help investors identify the particular situation when it takes place in the market. Let us try to understand those indicators.

• The best indicator of short covering in stock market is sudden and sharp price movement. After a downtrend in prices for a long time, if the price suddenly start rising and that too very quickly, it is a sign of short covering. It indicates that sellers who shorted, as not buying back the securities, resulting in upward price movement.
• The volume of trading is also a factor that indicates short covering in stocks. It along with price rise, the trading volume also increases, This also drives up the demand for the security.
• The open interest data is also a very good indicator to understand the situation. This information is available periodically, which may be hourly, daily, weekly, etc. It is important to know how to read the data from various financial sites.
• Various news, social media updates or market analysis interview by experts throw a lot of light on the matter. A good trader will always track such news and discussions to know the market sentiment better. This will help them make decisions on time regarding taking new positions or closing them, thus avoiding or controlling losses.

However, it is necessary to make a proper analysis along with the above indicators to ensure the proper identification of the short covering in call option or put option because the market dynamics can be highly complex and influenced by various factors.  

• 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 assets as it involves buying of stock. Initially, when a few short positions 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 squeeze. This buying leads to more short covering strategy 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.

• 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 which is a short covering strategy.
• 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, a speculator shorts ABC Ltd. for $55 because of some news claiming financial irregularities in the company, and as a result, the price drops to $50. But soon, the claim was found to be frivolous, due to which stock recovered instantly to $56, which led to covering by short sellers to avoid losses causing the short squeeze.

Both the above terms are very widely used in the field of finance and stock market for trading purposes. However, it is important to understand the differences between them in detail. So let us go through the points as given below:

• The short covering in stocks is a position that traders take after they anticipate that the price of the asset will not go down or perhaps go up. The latter is the position that traders take if they anticipate that the asset will compulsorily go down.
• The former is the step taken after already shorting or selling the asset, which is a process where the traders do not actually possess the asset but borrow it on the basis of a contract. The latter is the first step, where the trader enters into a contract of selling the asset or the security which is the very first position of the shorting process.
• The aim of the short covering in call option or put option is to close the open short position or the contract for sale, whereas the latter aims to create or open a short or sale contract.
• In the former, the trader plans to secure the profits earned from the sale contract before the price of the security goes up but in case of the latter, the trader plans to make profit from fall in prices of securities.
• As a result of the former, the upward buying pressure on the stock or security or asset increases, which leads to a buying tendency created in the market, leading to further rise on prices. But the result of the latter is a selling pressure created in the market for the security, which may lead to further fall of prices, if lots of traders start shorting the stock.

Thus, we can see that both the above strategies are some frequently used trading techniques that traders continuously use in the financial market, to take advantage of price movements to earn profits. If a trading strategy is taken, it is important to understand these terms well so that becomes possible to identify the market sentiments and take positions accordingly. With continuously growing innovation in the financial market, and increase in participants, such strategies are gaining prominence and educating investors about different financial knowhow.

This has been a guide to Short Covering and its definition. We explain how to identify it with example and differences with short build up & short squeeze. You can learn more about financing from the following articles –

• Stop-Limit Order
• Market Neutral
• Spread Betting
• Naked Shorting
• Contango vs. Backwardation