Short covering: what is it and how does it work?

Finger pointing on market chart data
Rebecca Cattlin
By :  ,  Former Senior Financial Writer

Short covering is a key part of the traditional process for short-selling shares. Although it applies to investors, speculative traders still need to keep their wits about them as covering can lead to short squeezes. Learn more.

What is short covering?

Short covering is the process of buying back shares to close out a short position. It’s what happens when an investor has sold a stock they don’t own by borrowing it from a third party and now needs to replace the assets.

Once they’ve bought back the same number of shares that they sold short, the transaction is said to be ‘covered’.

How does short covering work?

To understand how short covering works, we first need to look at how to short sell a stock.

Short selling is a way of betting that a market will decline in price. To do so, an investor will borrow shares from a lender, sell them at the current market price, and buy them back at a later date.

Short covering is just the act of exiting a short trade by buying the correct number of shares. It doesn’t necessarily tell us the outcome of the trade – whether it was a winner or a loser.

Short covering only applies to investment positions – not shorting derivatives. When you trade stocks with CFDs, futures or options, you won’t need to borrow the underlying asset, so nothing needs to be replaced at the end of the transaction.

What happens after short covering?

After a short covering, a trader can realise any profits or losses. 

If the market fell as the trader predicted, then they could buy back the shares and return them to their lender – pocketing the difference in price for themselves. This would mean they’d covered their short trade for a profit.

If the market increased in value instead, the lender might want the shares back so that they can profit from the increase in value. In this case, the short seller would have to buy back the shares for more than they sold them for. In this instance, covering the short trade can result in potentially unlimited losses.

To exit a short position with a derivative, you’d just click ‘close’ in the trading platform, and your profit or loss will be calculated depending on how far the market has moved in your favour or against you.

Short covering example

An investor believes that ABC shares are going to decline in value in the short term. To profit from the fall, they borrow 100 shares of ABC from a third party and sell them at the current market price of $10 each – resulting in a position of $1000.

Say the shares did fall in value down to $8, they could cover the 100 ABC shares by repurchasing them for $800 total. Once they returned the $800 worth of shares, they would keep the $200 difference.

However, if ABC’s share price had risen to $12 instead, the lender could’ve demanded the shares back. In this instance, the investor would have to cover the position for $1200, giving them a $200 loss.

Short squeezes and short covering explained

A short squeeze, which is less commonly known as a short covering rally, is what occurs when there is a surge in covering activity.

When an asset’s price increases unexpectedly, short sellers rush in to close their positions before losses stack up too much, or their broker invokes a margin call – which is what happens when the funds in the account no longer maintain the position. As short covering increases, it pushes the price of the market up even higher.

A common example is the GameStop short squeeze, which was caused by retail traders buying shares in the failing stock to inflate its price and cause hedge funds who had sold the stock short to have to cover their trades for a loss. It’s estimated that GameStop short sellers lost a total of $3.3 billion during the 2021 short-covering rally. 

Using open interest for short covering

One of the most common ways of assessing risk when short selling is to look at short interest – that is the number of shares that have been sold short and remain uncovered.

To calculate the short interest, you’d divide the number of a company’s shares that have been shorted by the company’s total outstanding shares, and then multiply that figure by 100.

For example, if a company has 30 million outstanding shares, and 1 million have been sold short, it would have a short interest of:

1 million/30 million = 0.03 x 100 = 3.3%

Anything over 20% would be considered a high short interest.

For assessing the potential risk to short sellers, it’s important to look at changes in this figure. An increase in short interest signals a bearish attitude, while a decrease in short interest indicates a bullish sentiment.

If short interest starts falling and market prices start rising, you could be looking at the start of a short-covering rally.

Short covering FAQs

Is short covering bullish or bearish?

Short covering itself is not inherently bullish or bearish, as there are several reasons a short seller might decide to close their position. For example, they might have reached their desired profit target, or their lender might require the shares back. But if there is a lot of short-covering activity, it can indicate a bullish rally.

How does short covering affect the share price?

Short covering can cause share prices to rise if enough positions are liquidated at once. One short seller closing a position is unlikely to have any impact, but if a rush of traders all cover trades, it can be enough to push prices higher and even lead to a squeeze. 

Related tags: Insights Stocks Equities

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