Short covering, also known as purchasing to cover, is the process by which an investor purchases shares of stock to close out a short position that has been opened. When an investor purchases the number of shares that they sold short and returns those shares to the lending brokerage, the short-sale transaction is said to be “covered” or completed.
What is short covering, and how does it work?
When an investor sells stocks that they do not own, this is referred to as “selling the stock short.” In simpler terms, short selling is a strategy for betting on declining a stock’s price in the future. Exiting a short position is accomplished by purchasing the borrowed shares to return them to the lender, referred to as “short covering” in the industry. Once the shares are returned, the transaction is considered complete, and the short seller has no further obligation to the broker in this regard.
There are various reasons why traders choose to close out their short positions. If the stock price falls, as short-sellers expect, the traders can purchase the company’s stock for less than the amount owed to the brokerage firm for the borrowed shares, resulting in a profit for the trader. Covering the short ensures that the trader makes a profit in this particular situation. Short sellers are well aware that shorting a stock carries the possibility of incurring unlimited losses because their downside risk is equal to the theoretically limitless gain potential of the stock price. The rise in stock prices may prompt traders to close out their short bets to limit their losses.
How does short-covering function?
Imagine that you have a gut feeling that the stock price of BadCo, which is now trading at $50, is likely to plummet. When you sell short 100 shares of BadCo for $50 a share, you earn $5,000 because you borrowed the shares from your broker and resold them. You make a $1,000 profit by returning the 100 borrowed shares to your broker, which allows you to close out your short position. When BadCo’s stock price falls to $40, you purchase 100 shares for a total cost of $4,000 (four thousand dollars).
An excessive amount of short covering can cause a short squeeze
When many traders have a poor outlook on a firm and decide to sell short the stock, this is called a short squeeze. A method known as naked short selling allows investors to sell short shares that have not been borrowed, resulting in the number of shares sold short exceeding the number of shares owned by a firm in the short market. Suppose investor attitude towards a firm shifts and a large number of investors attempt to cover their short sales at the same time. In that case, this can result in a “squeeze” on the number of shares available for purchase, leading the price of a specific stock to jump to a higher level. It is also possible for the original brokerages that lent the shares to issue margin calls, which means they must repay for all of the shares they loaned. Additionally, this increases the number of investors attempting to close out their short positions, which can potentially create significant jumps in the company’s stock price.
An example of a short-covering
Traders were bearish on the brick-and-mortar video game retailer GameStop (NYSE: GME), for example, because the business was losing sales to digital distribution methods. Because more and more video game players are choosing to download games rather than purchase them in stores, the corporation has struggled to diversify its revenue streams into other sales channels. In early 2021, almost 70 million shares of GameStop stock had been sold short, even though the business only had 50 million shares of stock outstanding at the time.
Despite forecasts, GameStop’s business prospects continued to improve. Investment firms with significant short holdings, as well as a considerable number of other investors, clamoured to have their bets covered. The above, combined with coordinated buying among Reddit forum members, increased the stock’s price dramatically. In less than one month, the stock price soared by nearly 1,700 per cent, allowing investors who owned GameStop stock outright to realise tremendous profits. In addition to demonstrating the dangers of thinking that short covering is always achievable, the GameStop example also demonstrates that not covering a short position can result in significant losses.
It can be challenging to identify good short squeeze plays; as a result, most investors should avoid allocating a significant portion of their portfolios to these types of transactions. Investors often prefer strong companies with positive business outlooks since they provide superior returns.
IMPORTANT TAKEAWAYS
Using purchase to cover orders, short covering is closing out a short position by purchasing back shares borrowed originally to sell short.
The short covering can result in either a profit, i.e., if the asset is repurchased at a price lower than where sold, or a loss, i.e., if the asset is repurchased at a higher price than where it was sold.
The short-covering may become necessary if there is a short squeeze and sellers are exposed to margin calls. Measures of short interest can aid in predicting the likelihood of a squeeze.
This article should give you a good idea on what short covering means
