Short Covering

Introduction of Short Covering

Short Covering means a transaction wherein the short-term investor buys the same quantity of securities of the company from an open market, so as to cover the short position created earlier for the securities of the said company, and such transaction may or may not result in profit for the investor.

Explanation

• Before understanding the meaning of short-covering, one needs to understand a few basic terms of financial markets. Normally, we buy security first and then sell it. However, the situation is the exact opposite in the case of short-covering, wherein the investor sells first and buys later on. Short means to sell a security. A short position means a situation wherein the investor has sold the security via borrowing the same from another person.
• So, in normal trade we “first buy and then sell the same. However, in case of short covering we are required to “first borrow the security, sell the same, cover up the short position by purchasing the securities in the open market and settle the same from the stock-lender”. This whole process is called as short selling.
• Thus, short covering occurs at the last stage of short selling wherein the investor will buy the required securities from the market and give it back to the lender. Basically, it is like taking a loan and repaying back. Obviously, the stock lender will charge stock lending charges for allowing the same.
• The obvious question arises is what actually is achieved through such short selling. Short selling is used by portfolio managers to cover up the downside risk of stock prices. Intraday investors and short-term investors prefer this method of investment to magnify their profits.

How Does It Work?

• The investor has first borrowed the stock from the stock lender. The stock lender is not concerned about how the investor will deal with the security lent. He is just concerned about receipt the stock after a specific period of time.
• With the said period he needs to purchase the stock and return it back to the lender along with stock lending charges. So, short covering helps the investor to close out his short position in respect of said security.
• So, the investor is at a profit if he able to cover the position at a price lower than the selling price. He will have to suffer the loss in case he is required to buy at a higher price than the selling price.
• It may happen that the lenders require the stock before the specific period is elapsed. In this situation, the intermediary (i.e. broker) tries to satisfy the lender through borrowing the same from another lender. In acute situations, the borrower is required to buy the stock at higher prices.

Example of Short Covering

Say a stock is trading at $ 500 now. The company is about to post it’s October 2020 quarterly results by end of the month. The market expects that the company is expected to post negative results. The short seller wishes to earn by short selling. He is expected that the price will fall by a minimum of 15%. He will close the position at a 12% downfall irrespective of the actual fall later on.

Solution:

Scenario 1

Scenario 2

Explanation

• Under scenario 1, the short seller has earned a net profit of $ 38125 due to negative results leading an actual downturn of the stock prices. If you observe, his only outflow was involved in stock lending charges.
• Under scenario 2, the stock prices surged due to the positive outlook of the results. The short seller has no option other than to buy the stocks at higher prices and he needs to cover the position within the time allowed by the stock lender. This situation leads to be short squeezing which further increases the stock prices for a short momentum.

How Short Covering Can Cause Short Squeeze?

• We understand the normal meaning of “to squeeze” anything. Short squeezing refers to a sudden increase in demand for the stock with a lower supply, resulting in the rapid increase of stock prices beyond the expected level.
• A short squeeze happens when the stock lender has demanded back the securities with the immediate need and the stock prices are presently trailing high. The investor will buy the securities in huge volumes resulting in a surge of market prices.
• Thus, short covering results in an increase in the market prices which may break the upper circuits. The rusk buying leads to a lower quantity of supply. A short squeeze is experienced only in such securities which suffer higher interest cost from the lender.
• Suppose a stock is currently trading at $ 40 and investors have already entered on the short position at $ 55. Due to surprising results in the next quarter, the stock jumps to $ 65 i.e. the investors are at loss. So as to limit the loss, the investors purchase the stock which leads to a further increase in the share price up to $75.

Short Covering Graph

Source: https://www.google.com/imgres?

• In the short covering, the bear market ends at the bottom of the graph. The long-term investors wait for the confirmation when the prices close in green signal in two consecutive trading sessions.
• The optimism line above means the resistance line. If the prices break the resistance level, the stock is said to be in an uptrend.

Short Covering Affect Stock Price

• The short sellers coverup their positions in case of short covering. There is no supply of stocks in the market. Yet the investors want to coverup their position by purchasing the stocks in huge volumes.
• By the rule of demand and supply, the prices eventually shoot up without any fundamental reason for the surge in prices.
• The short-term investors have closed their position but this has led to an unwanted increase in price. The unknown investors consider this as an “uptrend” and further buys the stocks. Such increase has no fundamental base. Thus, over the period of time, the stock will rebound back to its fundamental price at the downside.

Conclusion

Short covering basically helps the short sellers to close their position created due to selling the stock earlier. The investor either gains or losses the money in case of short squeezing occurred as a result of short covering. However, this short covering may be done by few voluminous short sellers, leaving the fundamental traders at the shock.

Recommended Articles

This is a guide to Short Covering. Here we also discuss the introduction and how does short covering work? along with the example. you may also have a look at the following articles to learn more –

1. Merger Arbitrage
2. Retail Investors
3. Accredited Investor
4. Tax Planning