Short Covering: Definition, Meaning, How It Works, And Examples

(Many of the links in this article redirect to a specific reviewed product. Your purchase of these products through affiliate links helps to generate commission for LiveWell, at no extra cost. Learn more)

Understanding Short Covering: A Complete Guide

Have you ever wondered why certain stocks experience sudden price surges? Often, this can be attributed to a market phenomenon known as short covering. In this comprehensive guide, we will delve into the definition, meaning, how it works, and provide some examples to help you grasp this concept fully.

What is Short Covering?

Short covering is a process in which investors or traders who have taken short positions in a stock decide to buy back the shares they previously borrowed and sold. When traders sell a stock short, they are essentially betting on its price to go down. They borrow shares from a broker, sell them on the market, and plan to repurchase the shares later at a lower price, thus profiting from the difference between the selling and buying prices.

However, if the stock unexpectedly starts to rise, these traders may panic as they face the risk of incurring significant losses. To mitigate this risk, they decide to cover their position by purchasing the same number of shares they initially sold. This process is known as short covering because they are essentially covering their short position by buying back the shares.

How Does Short Covering Work?

Short covering can occur due to various reasons, but the basic mechanics involve the following steps:

1. A trader observes a stock that they believe will decline in value.
2. The trader borrows shares of the stock from a brokerage firm and sells them on the market at the current market price.
3. If the stock price falls as expected, the trader buys back the shares at a lower price, returning them to the broker and pocketing the difference as profit.
4. However, if the stock price starts to rise, the trader risks incurring losses as they will have to buy back the shares at a higher price.
5. To limit their losses, the trader decides to cover their short position by buying back the shares, contributing to increased buying pressure in the market.
6. This increased demand from short covering can lead to a short squeeze, which is a situation where a rapid increase in the stock price occurs due to the rush of short sellers buying back shares.

Examples of Short Covering

Let’s take a look at a couple of examples to help illustrate how short covering works:

Example 1: XYZ Company

Trader A believes that the stock of XYZ Company is overvalued and is likely to decline. They decide to sell short 100 shares of XYZ Company at $50 per share.

However, an unexpectedly positive earnings report causes the stock price to rapidly rise to $75 per share. Fearing further losses, Trader A decides to cover their short position by purchasing 100 shares at the new market price of $75 per share.

As a result, Trader A incurs a loss of $25 per share (the difference between their initial selling price of $50 and the buying price of $75 per share).

Example 2: ABC Corporation

Trader B believes that the stock of ABC Corporation is overhyped and expects a decline. They sell short 500 shares of ABC Corporation at $100 per share.

Unexpectedly, news breaks of a potential merger for ABC Corporation, causing the stock price to skyrocket to $150 per share. Concerned about the potential for further losses, Trader B decides to buy back the 500 shares at the higher market price.

As a result, Trader B incurs a loss of $50 per share (the difference between their initial selling price of $100 and the buying price of $150 per share).

Conclusion

Short covering is an essential concept to understand for both seasoned investors and those new to the financial markets. It involves the process of closing out a short position by buying back shares that were initially sold short. As traders rush to cover their positions due to rising stock prices, short covering can lead to a short squeeze and a surge in stock prices. By grasping these intricacies, investors can gain valuable insights to navigate the market more effectively.