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Short covering is a stock trading phenomenon that occurs when traders who have previously sold a stock short buy it back to close their position. This process can drive up the stock’s price, especially if multiple traders rush to cover their positions at the same time. Short covering often happens when unexpected news or price movements make continued short positions riskier. It is a risk management tool used in many short trading strategies. Investors who are not sellers but understand short covering may use it to anticipate price rebounds or capitalize on volatility.
A financial advisor can help you assess the risks of short selling, develop exit strategies for covering positions and manage potential losses with an investment plan.
Short covering is the process of repurchasing shares that were previously sold short to close out a position. It is a common but not universal part of short selling strategies that comes into play when share prices for a shorted stock begin rising.
To understand short covering, it’s important to first recognize how short selling works. In a short sale, an investor borrows shares from a broker and sells them on the open market, expecting the stock’s price to decline. If the price drops, the investor can buy back the shares at a lower price, return them to the lender and pocket the difference as profit.
However, if the price rises instead, the short seller faces losses and may need to buy back shares at a higher price. If a stock rises too much, brokers may issue margin calls, requiring traders to buy shares or contribute additional money to their account to cover their short positions and meet collateral requirements.
In cases of widespread short covering, a stock’s price can rise rapidly in what’s known as a short squeeze. This often happens when traders rush to exit losing positions, creating a surge in buying activity that drives the stock even higher.
As an example, let’s break down a short sell and a short cover:
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Short sell. The investor shorts 100 shares of XYZ at $50 per share, expecting the price to drop.
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Short cover. To close the position, the investor buys back the shares (covers the short). If the price drops to $40, they profit $10 per share. If the price rises to $60, they cover the short at a $10 per share loss.
When prices of a widely shorted stock rise significantly, many short sellers are likely to scramble to buy shares at the same time. This buying pressure can cause the price to climb even higher, compounding short sellers’ losses.
