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What is Short Covering

15 Jun 2023

Introduction

Leverage plays a crucial role in the financial markets. It amplifies potential returns on investment and involves utilizing borrowed capital or securities to finance the trading of financial assets.

Among the strategies employed under leverage, short selling and covering stand out. Short selling allows investors to profit from falling asset prices by borrowing and selling them. On the other hand, covering entails repurchasing the borrowed assets to close out the position.

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Here we'll discuss one of these strategies, short covering in detail, to help you navigate the complexities of the financial landscape with greater agility and potential profitability. Let's get started.

What is short covering?

Short covering involves buying back borrowed securities to close a short position, resulting in a profit or loss. Known as 'buy o cover', this transaction is crucial when the price of the underlying security rises.

For example, if 1000 shares of ITC Limited were sold short at Rs. 230 and the price drops to Rs. 210, buying them back at the lower price yields a profit of Rs. 20 per share and Rs. 20,000 overall.

Simultaneously, if the price rises to Rs. 250, short covering becomes necessary to avoid additional losses of Rs. 20,000. Short covering safeguards traders from further downside in a short position.

What are the essential features of short covering?

The essential features of short covering are as follows:

  1. Opportunity- In a bearish opportunity, a trader takes a short position by borrowing and selling shares at a lower price.
  2. Waiting Period- A trader must wait for the underlying security price to fall, known as the waiting period.
  3. Short Period- In a short period, the profit potential is limited, while the risk is unlimited.
  4. Revenue- Short covering is a crucial step in securing revenue for a trader in line with their expectations.
  5. Short Covering- When you cover the short, a trader locks in the profit earned from the transaction, capitalizing on the expected price movement.

How does short covering work?

Investors sell stocks they don’t own, betting on a decline in their price. This is when short selling occurs. Closing the short position involves short covering. Here, investors purchase borrowed shares to return them to the lender. Once returned, the transaction is complete, releasing the short seller from further obligations to the broker.

Traders close short positions to profit when stock prices fall, ensuring they pay less to the brokerage firm than the borrowed shares’ value. Short sellers understand the risk of unlimited losses, as their downside matches the stock price’s unlimited gain potential. Rising stock prices often prompt traders to limit losses by closing their short bets.

What happens in the case of too much short covering?

In the case of too much short covering, investors experience a short squeeze. It occurs when many traders sell short a stock due to a negative outlook. Naked short selling enables selling shares that investors have not borrowed. This results in more shares sold short than owned by the firm. If an investor's sentiment shifts, leading to a rush to cover short sales simultaneously, it can squeeze available shares, which causes the stock price to surge. The original brokers' issue margin calls that demand repayment for the loaned shares. This prompts more investors to close short positions, potentially causing significant jumps in the company’s stock price. Short squeezes can have a profound impact on stock prices and market dynamics.

Conclusion

Short covering involves repurchasing borrowed securities to close open short positions. Short sellers typically have shorter holding periods than long investors due to the risk of a short squeeze caused by increased buying pressure and short covering. To mitigate potential losses, these sellers quickly cover their short sales when market sentiment turns. The risk of disorderly short covering is higher when there is a greater short interest and short interest ratio (SIR) in a stock’s float.

Related Articles: Benefits of Short Selling in Futures | What is short selling in share market | What are the precautions to take when short selling in equities

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