What is Short Covering and How Does it Work?

You may have come across the term "short covering" in the stock market and wondered what it means. Maybe you saw a stock suddenly rise rapidly and heard someone say, "Oh, that’s because of short covering!" But, what exactly is short covering? In this article, we'll simplify this market concept and explain how it works.

• Table of contents

• What is short covering?
• How does short covering work?
• Monitoring short interest
• What is the difference between short interest and the short interest ratio?
• Example of short covering
• What are the risks associated with short covering?

What is short covering?

In simple words, short covering means buying back shares or stocks you earlier sold (or "shorted"). Shorting or short selling is the practice of selling shares that a trader doesn’t own, expecting the price to fall. If the price does fall, the trader buys the shares back at a lower price and books a profit. But if the price rises instead, they have to buy the shares at a loss. In both cases, the act of buying back the shares to close the short position is known as short covering.

To summarise the meaning of short covering clearly:

• Investors sell shares they don't own (this is called "short selling").
• They expect prices to drop.
• If prices fall, they buy back shares at a lower price to make a profit. This is short covering.
• If prices rise, they still need to buy back the shares at a loss.

Read Also: Short Selling: Meaning, Benefits, Risk and Examples

How does short covering work?

To clearly understand how short covering works, let's break it down step by step:

• Short selling: Investors borrow shares from their broker and sell them immediately at the current market price, believing the price will soon drop.
• Waiting period: Investors wait, hoping that the share price will go down, allowing them to buy back the shares at a lower price later.
• Short covering: If the stock price drops, they buy the shares back at a cheaper rate and make a profit. If the stock price rises instead, they will still need buy the shares back.
• Closing position: Once they've repurchased the shares, they return them to the broker, closing their "short" position.

The key here is that when many traders start short covering at once, it creates additional buying pressure. This sudden rush can cause stock prices to jump even higher, which can then trigger even more short covering, a situation known as a "short squeeze."

Monitoring short interest

Traders and investors watch something called "short interest" to track short selling in stocks:

• Short interest: The total number of shares that investors have sold short but have not yet covered (or repurchased).
• High short interest means many investors believe the stock price will fall.
• If the price rises unexpectedly, investors rush to cover their shorts, pushing the stock price even higher.
• If the price falls as expected, short sellers will also start covering to lock in profits.

Monitoring short interest can help predict sudden price moves due to short covering, either from panic buying or profit-taking.

What is the difference between short interest and the short interest ratio?

Investors often confuse these two terms. Let's understand the difference:

• Short interest: Refers to the actual number of shares currently sold short and not yet repurchased.
• Short interest ratio: Shows how many days it would take short sellers to buy back all shorted shares, based on average daily trading volume.

A higher short interest ratio means it could take a long time for short sellers to cover, possibly causing a big price rise when they finally buy. This might happen either when traders are taking profits or trying to limit mounting losses.

Read Also: Price Action Trading: Meaning, Benefits and Strategies

Example of short covering

Let's look at a simple example of short covering to make it easy to understand:

• Rahul believes that the stock price of XYZ Ltd. will drop from Rs. 200 to Rs. 180.
• He borrows 100 shares and sells them at Rs. 200, hoping to buy back later at Rs. 180.
• If the stock does drop to Rs. 180 and Rahul buys the shares back, he earns Rs. 20 per share. This is short covering with a profit.
• However, if the stock rises to Rs. 220 instead, Rahul panics and quickly buys the shares back at Rs. 220, losing Rs. 20 per share.
• Rahul’s act of buying the shares back, whether to take profit or to stop losses, is called short covering.

This is one of many clear examples of short covering in action.

What are the risks associated with short covering?

Although short selling might seem tempting, it carries significant risks:

• Unlimited losses: If a stock’s price keeps rising, losses could be significant.
• Short squeeze: A sudden rise in share prices could lead to rapid short covering, further increasing losses.
• Borrowing costs: Short sellers may have to pay fees to borrow shares, making short covering costly.

These risks mean short covering should be approached carefully, especially by new investors.

If you're a mutual fund investor who’s wondering how short covering might impact your investments, here’s what you need to know. Generally, mutual funds in India do not actively participate in short selling or short covering because of strict regulations. However, fund managers carefully monitor short interest because high short covering activity can rapidly increase a stock’s price, influencing their investment decisions.

Conclusion

Short covering is a powerful concept in stock markets that explains sudden jumps in share prices. When short sellers realise their bet against a stock is wrong, they rush to buy shares back, pushing prices higher quickly. But even when their bets are right, they still have to cover the short to realise profits. By learning about short covering, investors can better understand market behaviour, avoid costly mistakes, and make smarter investment decisions.

FAQs

What does short covering indicate?

Short covering indicates that investors who bet on a falling stock price are closing their short positions, either because they were wrong and want to cut losses, or because they were right and are booking profits. It usually means there could be a quick and sharp rise in the stock price.

Is short covering bearish or bullish?

So, short covering itself isn't inherently bullish or bearish. It depends on the context:

• If the price is falling and short sellers cover, it can be neutral or mildly bullish.
• If the price is rising and short sellers cover, it can be strongly bullish due to the extra buying pressure.