Short covering, also known as buying to cover, occurs when an investor buysshares of stock in order to close out an open short position. Once the investor purchases the quantity of shares that he or she sold short and returns those shares to the lending brokerage, then the short-sale transaction is said to be covered.
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What is short covering?
What is short covering?
A short cover is when an investor sells a stock that he or she doesn't own, it's known as selling the stock short. Essentially, short selling is a way to bet that the price of a stock will decline. The way to exit a short position is to buy back the borrowed shares in order to return them to the lender, which is known as short covering. Once the shares are returned, the transaction is closed, and no further obligation by the short seller to the broker exists.
Traders decide to buy to cover their short positions for several reasons. If a stock's price drops, as short sellers predict, then the company's shares can be purchased for less than the trader owes the brokerage for the borrowed shares. In this instance, covering the short locks in a profit for the trader. Short sellers are aware that shorting a stock creates the potential for unlimited losses since their downside risk is equal to a stock price's theoretically limitless upside. A stock rising in price can also prompt traders to cover their short positions in order to limit their losses.
How short covering works
How short covering works
Let's say you have a feeling that BadCo's stock price, currently trading at $50, is about to drop. You sell short -- meaning borrow from a broker and resell -- 100 shares of BadCo at a price of $50 per share, which nets you $5,000. When BadCo's share price declines to $40, you buy 100 shares, which costs you $4,000. You return the 100 borrowed shares to your broker to cover your short position, and earn a profit of $1,000.
Too much short covering can cause a short squeeze
A short squeeze can occur when many traders have a negative outlook on a company and choose to sell short the stock. A practice known as naked short selling allows investors to sell short shares that have not actually been borrowed, which can push the number of shares sold short above the company's actual share count. If sentiment about the company changes and too many investors attempt to simultaneously cover their short sales, that can put a "squeeze" on the number of shares available for purchase, causing the particular stock price to spike to a higher price. The original brokerages that lent the shares can also decide to issue margin calls, meaning that all shares they loaned must be returned immediately. This further increases the number of investors trying to cover their short positions, which can cause further sharp gains in the company's share price.
Margin Call
A margin call is when you’re required to deposit more funds to keep the amount of your investments above the margin.
Short covering example
Short covering example
As just one example, many traders held a negative outlook on the brick-and-mortar video game retailer GameStop (GME -4.93%) because the company was losing sales to digital distribution channels. Video game players are increasingly opting to download games instead of buying them at stores, and the company has been struggling to diversify into new sales channels. Roughly 70 million shares of GameStop stock had been sold short in early 2021 despite the company having only 50 million shares of stock outstanding.
GameStop's business outlook defied expectations by improving, and this, coupled with coordinated buying among Reddit forum members, caused the stock's price to begin to significantly increase. The investment firms with large short positions, among many other investors, clamored to cover their shorts. The stock's price increased by nearly 1,700% in less than a month, enabling investors who owned GameStop stock outright to enjoy incredible gains. But the GameStop example also illustrates the risk of assuming that short covering is always possible and proves that not being able to cover a short position can result in massive losses.
Identifying successful short squeeze plays tends to be difficult, and most investors shouldn't structure any significant portions of their portfolios around these types of trades. Investors are generally much better served by backing strong companies with favorable business outlooks.
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Keith Noonan has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
FAQs
Short covering, also known as buying to cover, occurs when an investor buys shares of stock in order to close out an open short position. Once the investor purchases the quantity of shares that he or she sold short and returns those shares to the lending brokerage, then the short-sale transaction is said to be covered.
What is meant by short covering? ›
What Is Short Covering? Short covering refers to buying back borrowed securities in order to close out an open short position at a profit or loss. It requires purchasing the same security that was initially sold short, and handing back the shares initially borrowed for the short sale.
What are the 10 stocks the Motley Fool recommends? ›
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Mark Roussin, CPA has positions in AbbVie, Alphabet, Coca-Cola, Microsoft, Prologis, and Visa. The Motley Fool has positions in and recommends Alphabet, Chevron, Home Depot, Microsoft, NextEra Energy, Prologis, and Visa.
Is short covering bullish or bearish? ›
Example to Know Short Covering Rally
An increase in short open interest signals a bearish trend, while a decrease in open interest indicates a bullish sentiment. And “When short selling open interest starts falling and market or stock price start rising, you can see a short covering rally starts”.
What is the difference between a short squeeze and a short covering? ›
Generally, securities with a high short interest experience a short squeeze. Contrary to a short squeeze, short covering involves purchasing a security to cover an open short position. To close out a short position, traders and investors purchase the same amount of shares in the security they sold short.
How to identify short covering stocks? ›
What are the two tips to spot short covering?
- A significant increase in the price of a stock, particularly one without clear news or trigger.
- In Options, Short covering can be spotted when the option price increases and the open interest declines.
Too much short covering can cause a short squeeze
Ultimately, the demand for the shares is so high that the price increases significantly. Additionally, the intermediaries who lent the shares may decide to issue margin calls.
What is the ultimate portfolio Motley Fool? ›
The Ultimate Portfolio for 2022 is a model portfolio built from stocks recommended in Stock Advisor and Rule Breakers, and works as an example for how you can better manage your risk through diversification without sacrificing your return potential.
What stock will boom in 2024? ›
Best S&P 500 stocks as of June 2024
| Company and ticker symbol | Performance in 2024 |
|---|
| Constellation Energy (CEG) | 86.0% |
| Deckers Outdoor (DECK) | 63.7% |
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The Short build up means to find the stocks whose future price has decreased and open interest increased. The Long Unwinding meaning is to find the stocks whose future price and open interest has decreased. The Short covering means to find the stocks whose futures price increases and open interest decreases.
What is the highest short squeeze ever? ›
- What are short squeezes? ...
- The greatest short squeezes of all time. ...
- 1923: Piggly Wiggly short squeeze. ...
- 2008: Volkswagen vs Porsche. ...
- The big short on Herbalife. ...
- 2020: Tesla stock price rally. ...
- 2021: The GameStop surge.
Measuring a short squeeze can involve a metric called the short interest ratio, a.k.a. "days to cover." It indicates, in days, how long it would take to cover or buy back all the shorted shares. Basically, you divide the number of shares sold short by the average daily trading volume.
What is an example of a short covering? ›
Example of Short Covering
Suppose XYZ company has 50,00,000 outstanding shares and 10,00,000 shares sold short. Its investors generally trade for 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, you can see that both ratios are pretty high.
How many days do you have to cover for a short squeeze? ›
How many days do you have to cover a short position? There is not a specific period that traders have to cover a short position. It depends on when the lender may request the number of shares to be returned by the investors.
Is short squeeze illegal? ›
Although some short squeezes may occur naturally in the market, a scheme to manipulate the price or availability of stock in order to cause a short squeeze is illegal. In the end, short-sellers are considered well informed investors who have the ability to identify overvalued stocks.
What is short covering vs long covering? ›
Short Covering: Close out position of Short, i.e Buying back the stocks to exit the short position. Long: Buy the stocks first and then sell it later. Short: Sell the stocks first(Without having stocks in Account) and then buy them later, before the final settlement.
What is short covering in angel one? ›
Exiting a short position is accomplished by purchasing the borrowed shares and returning them to the lender, a process known as short covering. Once the shares are returned, the transaction is over, and the short seller has no further duty to the broker.
What is a short covering event? ›
Short covering is a specific step in a short-selling strategy. It refers to the act of buying back borrowed stock to return it to a lender. In doing so, you've covered your short position, and you'll be able to meet your obligation to return the stock.
What is short covering in commodities? ›
Short covering is simply closing out a short position by buying back the security sold when going short. For a short covering to be successful, the security must decline in price, allowing the trader to profit from the trade.
