What is Short Covering?
Short covering refers to buying back borrowed securities in order to close open short positions at a profit or loss. It requires the purchase of the same security that was initially sold short, since the process involved borrowing the security and selling it in the market. For example, a trader sells short 100 shares of XYZ at $20, based on the opinion those shares will head lower. When XYZ declines to $15, the trader buys back XYZ to cover the short position, booking a $500 profit from the sale. This process is also known as “buy to cover.”
- Short interest refers to the number of shares sold short as a percentage of total shares outstanding.
- The short interest ratio (SIR) is computed as total shares sold short, divided by the security’s average daily trading volume.
- The risk of short covering, i.e. whether or not the security will be subject to a short squeeze, can be gauged by short interest and the SIR.
How Does Short Covering Work?
Short covering is necessary in order to close an open short position. A short position will be profitable if it is covered at a lower price than the initial transaction and will incur a loss if it is covered at a higher price than the initial transaction. When there is a great deal of short covering occurring in a security, it may result in a short squeeze, wherein short sellers are forced to liquidate positions at progressively higher prices.
Short covering can also occur involuntarily when a stock with very high short interest is subjected to a “buy-in”. This term refers to the closing of a short position by a broker-dealer when the stock is extremely difficult to borrow and lenders are demanding it back. Often times, this occurs in stocks that are less liquid with fewer shareholders.
The higher the short interest and short interest ratio, the greater the risk that short covering may occur in a disorderly fashion. Short covering is generally responsible for the initial stages of a rally after a prolonged bear market or a protracted decline in a stock or other security. Short sellers usually have shorter-term holding periods than investors with long positions, due to the risk of runaway losses in a strong uptrend. As a result, short sellers are generally quick to cover short sales on signs of a turnaround in market sentiment or a security's bad fortunes.
Example of Short Covering
Consider that XYZ has 50 million shares outstanding, 10 million shares sold short and average daily trading volume of 1 million shares. XYZ has short interest of 20% and a SIR of 10, both of which are quite high, suggesting that short covering could be difficult.
XYZ loses ground over a number or days or weeks, encouraging even greater short selling. One morning before the open they announce a major client that will greatly increase quarterly income. XYZ gaps higher at the opening bell, reducing short seller profits or adding to losses. Some short sellers want to exit at a more favorable price and hold off on covering while other short sellers exit positions aggressively. This disorderly short covering forces XYZ to head higher in a feedback loop that continues until the short squeeze is exhausted while short sellers waiting for a beneficial reversal incur even higher losses.