What is Short Covering?

In the financial markets, leverage is used extensively to increase the potential return on investment. Leverage involves using borrowed capital or securities to fund a financial asset. Short selling and covering are strategies that incorporate leverage to maximize returns.

What Is Short Covering in Share Market?

To understand Short Covering, it is important to touch base on short selling. The concept of Short Selling refers to a transaction where a trader borrows a security and sells it in the open market intending to repurchase it at a lower price. Typically, a short sell transaction is executed when a trader expects the price of the security to fall in the short term. Short selling is also referred to as short positioning.

Short covering means the purchase of a security to close out an open short position in the market at a profit or a loss. Short covering in stocks entails purchasing the security that was short sold and simultaneously returning the securities which were originally borrowed.

Below are the essential features of short covering

• Opportunity –The trader is bearish and expects a fall in the price of the underlying asset.
• Short Position –The trader has borrowed shares and sold them for a lower price. In this case, the profit potential is limited whereas the risk is unlimited.
• Waiting Period – The waiting period refers to the time required for the market price of the underlying security to fall. The trader must wait for the stock price to drop to close the short position.
• Short Covering – Once the price of the security falls, the trader buys back the exact number of shares that were initially borrowed.
• Revenue – Since the price movement is per expectation, the trader earns a profit from the transaction. Covering the short locks in the profit for the trader.

For example, the shares of ITC Limited are trading at Rs. 230. A government announcement is expected which may lead to an increase in the tax liability for ITC Limited. You expect the price to fall and borrow 1000 shares of ITC Limited at Rs. 230 and sell them at the current market price of Rs. 230.

Within a few weeks, the price of ITC Limited is Rs. 210 and so you purchase the shares at the prevailing market price of Rs. 210. Hence, the gain from the transaction is the difference between the purchase and selling price of the borrowed stock. In this case, you earn a profit of Rs. 20 per share and an overall profit of Rs. 20,000 from the transaction.

In a short sell position, if the price of the underlying security rises then a trader may be forced to short cover to avoid loss. As a result, traders may rush to opt out of the short position by buying back the stock.

In the above example, let’s suppose the price of ITC Limited rises to Rs. 250. In this case, you may rush to close the position to avoid further loss. The loss on such a sale is Rs. 20 per share with an overall loss of Rs. 20,000 from the transaction.

Too much short covering can cause a short squeeze

A short squeeze primarily occurs when the stock price of the underlying asset does not move in line with expectations. Too many traders rush in to cover their short sale and that can put a ‘squeeze’ on the number of shares available for purchase. Ultimately, the demand for the shares is so high that the price increases significantly.

Additionally, the intermediaries who lent the shares may decide to issue margin calls. Margin calls indicate that the shares loaned are to be returned immediately. This may also lead to an increase in the number of traders trying to cover their position and the price of the underlying security.

Special Considerations

Short Interest and Short Interest Ratio are two important parameters to assess the risk involved with short covering in the share market. Short interest and short interest ratio are directly proportional to the risk of short covering occurrence in a disorganized manner.

The holding period for short sellers is comparatively lower than for the traders with a long position. The reason being short-sellers are potentially exposed to unlimited loss in case of a strong uptrend. Hence, short-sellers are prompt to cover short sales in case of a change in market sentiment.

Generally, short covering in stocks is responsible for the initial increase in price after a persistent bear trend or drastic fall in prices of the security. Identifying a short squeeze tends to be difficult and traders must be careful not to structure a sizable portion of their portfolio to such trades.

Short covering is an interesting trading opportunity to not only profit from the fall in prices but also close out an open short sell position.