In the stock market, you might have heard from market participants and news channels saying that traders in the market are covering short positions. As a beginner, you might be wondering what is short covering or what covering a short position means.
In this article, we will discuss the following two important things on short-covering;
- What is short covering in the stock market?; and
- Why and when traders cover their short position?
We will also take one example to make sure that you understand the basics of short covering.
The short covering process is part of short selling.
Before knowing what is short-covering, we suggest you read our article on short-selling in the stock market. You have to understand the concept of short-selling to understand how to cover a short trade. It’s also referred to as short positioning or selling the stock short.
What is short covering in the stock market
Short covering occurs when a trader decides to close out an open short position in the stock market.
Traders go for short selling when they bet that the price of a stock will decline shortly.
In the first step to short selling, they borrow securities from the broker to sell in the open market to get money. Its a kind of loan given by the broker with an agreement to return the same number and type of securities. They can do it only by buying from the market.
The way to close or exit a short position, which is by buying back borrowed securities to return it to the lender, is known as short covering.
If the share price has gone down while buying from the price at which securities were originally sold in the open market, traders make a profit.
On the flip side, they will have a loss if prices move up instead of coming down.
When prices move up, to cut losses short-sellers start buying securities from the open market to cover their short-selling position.
In simpler words, short-covering refers to the purchase of securities by a trader to close his/her short position in the stock market.
This is why short covering is also known as buying to cover.
When we have more number of short positions in the market, people start buying to square off their position, and that leads to the market going positive. Therefore short-covering might lead the market to positive. This price rise may not sustain for a long period, as it’s a temporary rise because people are covering short positions.
Mr. X sells short of ABC limited shares at Rs 100 assuming that prices of the stock will come down shortly which will enable him to buy back at a lower price to return to the broker.
When ABC limited’s share price decline to Rs 90 or a price below Rs 100, the traders might buy back the required number of stocks to cover the short position by assuming it won’t go further down.
The difference between Rs 100 and Rs 90, which is Rs 10, is Mr. X’s profit. This process is known as buy to cover or short covering.
In this above example, Mr. X has earned profit. However, it doesn’t mean you or Mr. X will always have a profit in short selling. The short covering can also result in a loss.
For instance, in our above example, assume that share prices of ABC limited has gone up to Rs 120 instead of coming down. Now, what Mr. X should do to cover a short-selling position. He must buy at Rs 120 or wait for the share price to decline. If he decided to buy at Rs 120 to cover the short-selling position, there will be a loss of Rs 20 per share, which is the difference between Rs 120 and Rs 100.
Therefore, the short covering can result in profit when you buy back shares lower than where it was initially sold.
The short covering can also result in a loss if you repurchase shares higher than where it was originally sold.
In other words, a short position will be profitable if you can cover it at a lower price than the initial transaction. You will incur a loss if the position is covered at a higher price than the initial transaction.
When the short covering is necessary
Assume for a moment you have taken a short position on ABC limited on the expectation that prices will fall in near future. Due to the expectation of a fall in price, many other traders have also taken short positions.
Suddenly, after the market hours, the company has announced the addition of a major client which will greatly increase their sales and will result in higher earnings.
Due to this news, ABC limited stock gaps higher at the opening bell.
Now what, such price increase either reduces short seller profits or will add to losses.
Due to this panic, certain short sellers will start covering their short position aggressively.
Such a situation will force the stock to head higher until the short squeeze is exhausted. If you haven’t covered your short position yet, then it might increase your losses.
Here are certain cases where traders prefer short covering;
- The stock dropped and the share is available less than the price of the sort sells due to which covering the short position can be a profitable end to the trade.
- When the shares are rising in price, the loss can be unlimited if it’s not covered in an early stage. To limit their losses when the market moves against them, traders consider covering their short position.
- Short squeeze, which can drive the share price higher due to too much short-covering by other short-sellers. In the end, due to the high price rise, you will be forced to cover your short position if you haven’t covered earlier.
- The trader is subject to margin calls.
- When lenders are demanding the stock back. It can happen if the stock is less liquid and is with few shareholders.
Short selling can be dangerous enough for beginners who are just starting in the stock market. As a beginner, you must understand how the stock market works and gain all the basics to advanced level knowledge before getting into stock trading.