Short Covering and Short Squeeze

The stock market attracts people across ages and offers ample opportunities for financial growth. With various products, like shares, ETFs , and Options, an investor can build strategies to suit their objectives. While studying various strategies one might come across terms that may be new and seem difficult to interpret. One such term is Short Covering. It is related to short selling and understanding this term can help unlock an interesting aspect of trading strategy.

Short covering is an element of the wider short-selling strategy and a technique to profit from the expectation that the price of a stock will fall, but what happens after short covering? Here, we describe what is short covering, how to spot short covering signals, and how it works.

What is short covering in the share market?

To comprehend the short-covering meaning, traders must get acquainted with the various stages of a short-selling strategy. First, individuals borrow shares from a broker. The second step is to sell them for cash in the open market. Thirdly, they buy back the shares and give them to the broker using the money. A short-selling strategy’s third step is known as short covering.

Thus, the act of an investor purchasing stocks to cover a short position is what short covering means. Short sellers are aware that shorting a stock implies the possibility of incurring losses as well. Trades on short positions could be closed to prevent losses if stock prices rise.

How exactly does short covering work?

It is a necessary practice of closing an open short position. Short covering could be beneficial if traders purchase back the share at a lower price than the selling price. They might suffer a loss if they buy at a higher price.

For instance, a trader feels that “XYZ stock”, priced at Rs. 100 is likely to plummet. Therefore, he short-sells 100 shares at Rs. 100 to make Rs. 10,000. Now, the share price falls to Rs. 90. He purchases the shares by paying Rs. 9000 and gives it back to the lender. The difference of Rs. 1000 is his profit. The second leg is known as the short covering. However, in the example, if the shares’ price surges, the trader has to suffer a loss.

What are the two tips to spot short covering?

Watch out for certain indicators to better spot short-covering stocks rally, even when there are no clear-cut signs of short covering.

Key short-covering indicators include the following:

  • 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.

The possibility of a short squeeze also needs to be kept in mind when there is significant short covering in a stock.

What is a short squeeze?

A short squeeze mostly happens when the underlying asset’s price does not move as anticipated. There may be a “squeeze” on the number of shares available for purchase if too many traders hurry to cover their short sell. The price eventually rises dramatically because of the extreme demand for the shares. In addition, the brokers who lent the shares gain the right to issue margin calls. Margin calls mean that the loaned shares must be repaid immediately. Additionally, this can cause more traders to try to cover their positions, which might increase the underlying securities’ price. Thus, taking advantage of the market decline through short selling and a short covering can be a great trading opportunity.

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Frequently Asked Questions (FAQs)

Short covering is a bullish indicator. This is because it means that investors are buying back shares that they had previously sold short. When investors buy back shares, it drives up the price of the stock.

After short covering, the price of the stock will typically rise. This is because the buying pressure from short covering will outweigh the selling pressure from other investors. However, the price of the stock may not rise indefinitely. If the underlying fundamentals of the stock are weak, the price may eventually fall back down.

Short selling is the act of selling a security that you do not own. You borrow the security from a broker and then sell it, with the expectation that you will be able to buy it back at a lower price later. Short covering is the act of buying back the security that you had previously sold short.

Here is an example of a short squeeze:

In January 2021, the price of GameStop (GME) stock rose sharply from around $20 per share to over $480 per share in a matter of days. This was caused by a number of factors, including a short squeeze. A large number of investors had shorted GME stock, betting that the price would fall. However, the price of the stock rose sharply, forcing these investors to cover their short positions at a loss. This buying pressure drove the price of the stock even higher, creating a short squeeze.

© Bajaj Financial Securities Ltd