If you want to know about short selling or short squeezes, you are going to have to understand what short covering is too. It is a move that is made when you already have a short position in play. With this article, we will go through what short covering is and why conduct a short cover? It may save you when you have made a bad play or profit from a good one. So why do shorts cover? Let’s read on.
What Does Short Covering Indicate?
The process of short covering is when a trader buys back securities that they’ve borrowed for a currently open short position in order to close it.
This purchase will result in either a profit when the asset is repurchased for a lower price than it was sold. Or a loss, if the asset’s price is now higher. Short covering requires that the same security that was sold short be purchased.
And the borrowed shares get returned to the broker. Short covering can also be called a buy to cover or buying to cover.
Let’s dig a little deeper. A short cover begins with an investor that sells a stock. Or another asset, we’ll use stocks from now on. In fact, they don’t own in a short position.
They borrow this stock from their broker to sell it to someone else. This short position is a bet that the price of the stock will decline.
A short position is exited by buying back the borrowed shares that were sold so that they can be immediately returned to the broker from which the original shares were borrowed.
When the shares are returned, the position is closed, and the transaction is finished with no further obligations of the trader to their broker.
Why Do Shorts Cover?
There are several reasons that a trader will choose to cover their short positions. If there is a drop in the stock’s price, as the “seller” had predicted, the seller can then purchase the shares in the company from any current seller for less than what is owed to the brokerage for the borrowed shares. This situation would be a profitable one for the trader when they cover the short.
When a trader shorts a stock, there is potential for unlimited loss because their downside is equal to the theoretical price of the stock, which is limitless because the stock’s price could go to infinity. Therefore a rising stock price will also cause traders to cover a short position to limit their losses. Why do shorts cover? Now you know.
A Short Covering Example
Say you are an immunologist and also an investor and find out about a new virus from China. You think this will cause ABC’s stock price, which is sitting at $100, to go down. You sell ABC short, borrowing 100 shares from your broker. And resell at $100, putting $10,000 in your pocket. But you owe your broker the 100 shares.
ABC’s stock does decline when the virus hits the U.S. and drops 30% to $70. And you cover your short by buying 100 shares for $7000. You give those shares to your broker. And now you have a profit of $3000 (less your fees).
The Short Interest Ratio
The more short selling there is, the higher the Short Interest Ratio (SIR), and the risk of short covering increases.
Short covering will often start a bull rally after a long bear market.
A short seller’s investment horizon is much shorter than a long holder’s because of their unlimited downside risk.
And it will cover their positions to prevent significant losses if investor sentiment changes.
If you’re going to short, make sure you know that the stock is going to move down. If the trade goes against you, then you could lose a lot of money.
And that’s something no trader ever wants to do.
The Short Squeeze (From Too Much Short Covering)
Short squeezes happen when many traders have a negative company outlook and sell short without borrowing the shares, AKA a “naked short”, pushing the number of shares shorted above the company’s actual share count.
Then something causes company sentiment to change, and many investors must cover their short sales, but there are no shares to buy, resulting in a “squeeze.” The price then spikes higher, and brokerages will issue a margin call to have shares returned, further increasing the need to buy shares to cover positions, and the price spikes even more.
The GameStop Short Squeeze
The video game retailer GameStop was in the news for its short squeeze. The company was losing sales to digital downloads. Seventy million shares of Gamestop had been sold short in Q1 2021; however, only 50 million GameStop shares total were outstanding.
GameStop’s earnings beating expectations, combined with retail online forum members buying and holding, caused the stock price to rise. “Smart money” which had purchased significant short positions, had to cover them, and GameStop’s price increased 1700% in a month.
Why do shorts cover? The Gamestop short squeeze exemplifies the risk possible with short covering. Massive losses are possible, so keep an eye on the SIR if you are shorting. Identifying a short squeeze is not easy, but when possible and early enough can be quite profitable.
In a bear market, selling short can undoubtedly be profitable but look for the short covers that indicate a turn towards the bulls. Building portfolios with a small proportion of assets selling short and for finding short squeezes while dedicating more to going long in companies with promising futures is probably the best strategy.
As always, never put at risk in one trade more than you can afford to lose, and good luck with all of your trades.