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Short covering is buying back borrowed securities to close an open short position.

Short covering is part of short selling, which is a risky way to profit from a depreciating stock.

Suppose Harry believes XYZ’s stock is going to drop in value. He borrows 10 shares to sell for $100 each, its current market price.

A month later, XYZ’s stock drops to $50 per share. Harry buys 10 shares at its new price and covers his open short position, or returns the shares he borrowed, making a profit of $500.

Harry predicted XYZ was going to lose value, and he was right. Had the stock risen in value, he’d have been short covering at a higher price than the borrowed shares he sold.

A short squeeze may occur on stocks with a lot of short covering. A short squeeze forces short sellers to cover their positions earlier than they planned, before the stock’s value climbs too high. Short sellers usually have a shorter trading horizon than investors who buy a stock expecting its value to increase.

Short covering can provide protection in a down market. It usually occurs in the early stages of a rally following a long bear market.

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