What is ‘Short Covering’
Short covering is buying back borrowed securities in order to close an open short position. It refers to the purchase of the exact same security that was initially sold short, since the short-sale process involved borrowing the security and selling it in the market. For example, assume you sold short 100 shares of XYZ at $20 per share, based on your view that the shares were headed lower. When XYZ declines to $15, you buy back 100 shares of XYZ in the market to cover your short position (and pocket a gross profit of $500 from your short trade). This process is known as short covering.
Also known as “buy to cover.”
BREAKING DOWN ‘Short Covering’
Short covering is necessary in order to close an open short position. A short position will be profitable if it is covered at a lower price than the stock was sold short and vice versa if the stock price has moved higher. When there is a great deal of short covering occurring in a stock, it may be result in a “short squeeze,” wherein short sellers are forced to liquidate their positions at progressively higher prices as the stock moves up rapidly.
Short covering may also happen on an involuntary basis in the case of stocks with very high short interest, which may subject short sellers to a “buy in.” This term refers to the closing out of a short position by a broker-dealer if the stock is extremely difficult to borrow and its lenders are demanding it back. Often times, this occurs in stocks that are less liquid with fewer shareholders.
Short Covering Risks
The risk of short covering, i.e. whether or not the stock will be subject to a short squeeze, can be gauged by a stock’s short interest and its short interest ratio (SIR). Short interest refers to the number of shares sold short as a percentage of total shares outstanding, while short interest ratio is computed as total shares sold short divided by the stock’s average daily trading volume.
The higher the short interest and SIR, the greater the risk that short covering may occur in a disorderly fashion. For example, consider a stock with 50 million shares outstanding, 10 million shares sold short and average daily trading volume of 1 million shares. This stock has a short interest of 20% and a SIR of 10, both of which are quite high, suggesting that short covering could be difficult.
Short covering is generally responsible for the initial stages of a rally after a prolonged bear market or a protracted decline in a stock. Short sellers usually have a shorter trading horizon than investors with long positions. This is due to the risk of runaway losses on a short squeeze, so they are quick to cover their short positions on any signs of a turnaround in market sentiment or a stock’s fortunes.