"Short covering" and "short squeeze" are different terms to describe a situation involving short positions. A short squeeze is a situation in which a security's price increases significantly, putting pressure on short sellers to close their positions and limit their losses.
Conversely, short covering involves buying back a security to close out an open short position.
Understanding the Difference Between a Short Squeeze and Short Covering
A short squeeze involves a rush of buying activity among short sellers due to an increase in the price of a security. The increase in the security price causes short sellers to buy it back to close out their short positions and book their losses.
This market activity causes a further increase in the security's price, which forces more short sellers to cover their short positions. Generally, securities with a high short interest experience a short squeeze.
Contrary to a short squeeze, short covering involves purchasing a security to cover an open short position. To close out a short position, traders and investors purchase the same amount of shares in the security they sold short. For example, a trader sells short 500 shares of ABC at $30 per share, and then ABC's price decreases to $10 per share. The trader covers their short position by buying back 500 shares of ABC at $10. The trader profits $10,000 (($30-$10)*500).
An Example of Short Covering
Let's say the short interest in company GHI is 50%. Suppose many traders and investors are short from $50 due to bad earnings, and the stock is currently trading at $35. However, over the next quarter, the company reports stellar earnings and doubles in value to $70. Since many traders are short, they would need to cover their short positions to limit their losses; this creates buying pressure on the stock and causes the price to increase to $80.