What is Short Covering?
Short covering is essentially related to a short-selling strategy where investors profit from the stock’s falling price. This involves selling a stock first and repurchasing it to complete the whole transaction.
The situation of short covering arises when an investor buys stock to close an open short position. The motive of an investor is to sell the stock at a higher price and buy it at a lower price. The entire process involves borrowing the stock from a lender, selling it, and then buying it from the stock market. The difference between the selling price and the buying price determines the profit.
What is short selling and short covering?
It refers to taking a short position in a particular stock without owning it. Short selling is done in the interest of taking profit from the falling stock price. In a bullish scenario, most traders are accustomed to buying first and then selling.
But short selling is ideal when markets are bearish. A trader sells a stock first and buys it back to cover this position and book his/her profit or loss. Short covering is the act of buying back shares to cover short positions.
Short selling occurs in stocks on an intraday basis for retailers, whereas institutions can do the same for a longer time frame.. In stock derivatives, carrying forward is allowed. Short sellers have a limited time to hold their short positions and need to cover them, unlike the buyers, who can hold for as long as they want.
Let’s understand this with an example.
A trader discovers that the stock price of company ABC will fall; Hhe borrows that stock from a broker and sells it to someone for ₹100. The stock starts falling, and the seller buys the stock for ₹75 and repays the number of shares he borrowed from the lender. In this transaction, the trader gains ₹25 per share. Buying back the stock is called short covering.
Identify short covering through open interest
Open interest shows the number of outstanding stocks to cover long or short positions. Short covering occurs when the open interest in a stock decreases and the price rises. This indicates large volumes of short positions are being closed, resulting in sharp upward movement in the stock price.
‘Short Interest’ and ‘Interest Ratio’
In this case, a seller can only hold a short position for a short duration unlike long-term investors. They use short interest and the interest ratio to ascertain the risk.
Short interest indicates the investor’s sentiment toward the stock. It shows the total number of open short positions. Any sharp movement in the short interest ratio can determine the bullishness or bearishness of the stock. Let’s understand this with an example.
Suppose Company ABC has 50,00,000 outstanding shares, and 10,00,000 shares have been sold short. Its investors trade 1,00,000 shares daily.
The company also has a short interest (SI) of 20% and a short interest ratio (SIR) of 10. As an investor, both ratios are high, i.e., the majority of the short positions are open. Hence, there can be an increased risk associated with short covering.
For example, company ABC has been performing poorly for several weeks. Therefore, most investors have started short selling. But one day, the company announces that it has bagged a big order. This indicates that they will get more income. They will result in a lower profit margin for short sellers as the prices will start increasing. If the process continues, many investors will face losses, and the situation can cause a short squeeze.
‘Short Covering’ and ‘Short Squeeze’ – What’s the relation?
Short squeezes occur for stocks with high demand and low supply. It is a market driven phenomenon. It leads to a massive increase in price. On the other hand, short covering involves buying the stock to cover the short position and is done by the trader at his will. Why is short covering necessary?
Short sellers always want to close their short position by short-covering a stock. Whenever the demand for a stock rises but has limited supply, the price of that stock tends to go up. As a result, short position takers try to close their position resulting in further price rises.
Short sellers buy them, creating more demand for that stock. It leads to a massive trend reversal of that particular stock, and new sellers eliminate it to restore its supply and stabilise its price.
Short covering is an essential part of the short-selling strategy.Short covering restores demand for stock and price stability to attract potential investors. It indicates the possibility of a short-term trend reversal and generates demand for fallen stocks.
Frequently Asked Questions
Why is short selling essential?
A short selling position in the stock helps restore the fair market of the stock that has been inflated in the short run because of bullish sentiment.
How does a seller short a stock and short-cover it?
A short seller sells stock at a higher price and buys it back at a lower price through the stock lending mechanism. This means that this stock is shorted to gain from a downward move and buying it back is referred to as short covering.
How does short covering affect the stock market?
Short covering increases volatility due to high demand and low supply, further pushing the stock prices and eliminating new shorts sellers from taking a position.