Short Covering Explained

Everything About Short Covering

What is short covering in the share market? Short covering is the essential element of a short-selling strategy. In short covering, investors make a profit (or loss) on betting that stock prices will decline.

This scenario arises when investors buy stocks to close the open short position. And later, they repurchase the same shares to return them to the lender. With this step, short-sale transactions get completed, and investors make a profit or a loss. 

Although, understanding short covering or buying to cover can be tricky. So, read this article and get practical insights with a short covering example. 

What is Short Covering? 

Stock short covering is also referred to as "buying to cover." And it's a significant part of the short-selling strategy. Here investors bet that the stock prices will decline. And they buy back the borrowed securities to close out their open short position at profit or loss.

It's the strategy where investors buy back the same securities that they sold short initially. They also hand back the shares borrowed from the broker to execute a short sale. 

For Example, a trader encounters that the share price of XYZ company will decline. Hence, he decides to sell short 500 shares of XYZ company at Rs 100 each.

And the share price declines as expected and is priced at Rs75. The trader buys back the 500 shares of the same company again. And doing this activity, he generates a profit of Rs 12,500.

How does Short Covering Work?

Short covering in the stock market is essential to complete the open short position. It can be profitable if you buy back at a lower price than the first transaction. However, it can also cause loss if you buy again at a higher price than an initial transaction.

Also, when many investors start using short covering for a particular company's securities. It can cause a short squeeze; it's the condition wherein investors are forced to liquidate a position at higher prices at the initially transacted. Also, their broker put margin calls to return the borrowed stocks within a limited period. 

Sometimes stock short covering also takes place when stock carries very high short interest and needs to be "buy-in." It's the broker-dealer's position when getting the stocks is tough. But the lenders are demanding to buy back again.

This condition occurs when the stock is less liquid and with fewer shareholders. In short, short covering in the share market takes place when an investor wants to get the advantage of short selling. 

Here you borrow the shares of the desired company from the broker. Once you have the shares, you sell these in the open market and generate cash. The next step occurs when you use the money to buy back the shares and return them to the lender.

These three steps are a crucial part of a short-selling strategy. And you either make a profit or loss based on the difference in value. 

For Example, if you sold borrowed shares at a high price and bought back the same shares at a low price. In this case, you will profit from the difference in money. However, sometimes there can also be a loss if your prediction does not work well. 

Special Considerations - Short Interest and Short Interest Ratio (SIR)

Generally, short sellers have shorter term holding time than investors. Therefore, they use short interest and short interest ratios to understand the risk volume.

Short interest tells investors about the market sentiment regarding the company's stock. It shows the total number of shares sold in the open market but not yet covered. Its short interest ratio gives the ideal result in percentage. 

Any sharp movement in the short interest ratio can show that the stock market can turn bullish or bearish. To calculate SIR, you can divide the number of shorts sold of the company's shares by the total number of outstanding shares and multiply by 100. 

Example of Short Covering

If you are reading this article, we assume you have understood short covering meaning in the stock market. Now let's get a little more insights about the same using a short covering example. 

Suppose XYZ company has 50,00,000 outstanding shares and 10,00,000 shares sold short. Its investors generally trade for 1,00,000 shares daily.

The company also has a short interest (SI) of 20% and a short interest ratio (SIR) of 10. As an investor, you can see that both ratios are pretty high. Hence, there can be an increased risk associated with short covering. 

XYZ company has been continuously losing its ground for several weeks. Therefore, most investors have started short selling. But one day, the company announced it had a significant client.

And they will now get more quarterly income. Now the company's shares will start giving a low-profit margin to short sellers. If the process continues, many investors can also face losses. This condition can also cause a short squeeze. 

Key Takeaways

Stock covering is the condition when investors assume stock prices will decline. They short-sell the borrowed stock and buy back the same to return the borrowed shares at a profit or loss.

Suppose investors buy back the shares at a lower price than sold-out money. They will make profits. However, if the scenario changes and they are repurchased at higher prices, they will face loss.