An investor taking notes on how short covering is used for investments.
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Short covering is a stock trading phenomenon that occurs when traders who have previously sold a stock short buy it back to close their position. This process can drive up the stock’s price, especially if multiple traders rush to cover their positions at the same time. Short covering often happens when unexpected news or price movements make continued short positions riskier. It is a risk management tool used in many short trading strategies. Investors who are not sellers but understand short covering may use it to anticipate price rebounds or capitalize on volatility.
A financial advisor can help you assess the risks of short selling, develop exit strategies for covering positions and manage potential losses with an investment plan.
Short covering is the process of repurchasing shares that were previously sold short to close out a position. It is a common but not universal part of short selling strategies that comes into play when share prices for a shorted stock begin rising.
To understand short covering, it’s important to first recognize how short selling works. In a short sale, an investor borrows shares from a broker and sells them on the open market, expecting the stock’s price to decline. If the price drops, the investor can buy back the shares at a lower price, return them to the lender and pocket the difference as profit.
However, if the price rises instead, the short seller faces losses and may need to buy back shares at a higher price. If a stock rises too much, brokers may issue margin calls, requiring traders to buy shares or contribute additional money to their account to cover their short positions and meet collateral requirements.
In cases of widespread short covering, a stock’s price can rise rapidly in what’s known as a short squeeze. This often happens when traders rush to exit losing positions, creating a surge in buying activity that drives the stock even higher.
As an example, let’s break down a short sell and a short cover:
Short sell. The investor shorts 100 shares of XYZ at $50 per share, expecting the price to drop.
Short cover. To close the position, the investor buys back the shares (covers the short). If the price drops to $40, they profit $10 per share. If the price rises to $60, they cover the short at a $10 per share loss.
When prices of a widely shorted stock rise significantly, many short sellers are likely to scramble to buy shares at the same time. This buying pressure can cause the price to climb even higher, compounding short sellers’ losses.
The GameStop short squeeze in early 2021 was a striking example of how short covering can fuel extreme price movements. At the time, hedge funds and institutional investors had heavily shorted GameStop (GME), betting that its stock price would decline due to financial struggles. However, retail investors, particularly those from the WallStreetBets subreddit, began buying large quantities of GME shares and options, driving up demand and pushing the stock price higher.
As the price surged, short sellers were forced to cover their positions by buying back shares at increasingly higher prices. This rapid buying activity created a feedback loop, where each new wave of short covering drove the price up even more, intensifying the squeeze.
GameStop’s stock, which had been trading under $20, soared to over $400 at its peak. The event caused billions in losses for hedge funds caught in short positions and highlighted the power of retail investors in modern markets. The GameStop case remains one of the most well-known examples of short covering triggering a massive price spike.
An investor researching how they could use short covering for their investments.
Short sellers aren’t the only ones with an interest in short covering. Other investors can leverage short covering to identify potential price movements and trading opportunities.
One common strategy is tracking short interest – the percentage of a stock’s float that has been sold short. A high short interest combined with rising prices can indicate the potential for a short squeeze that will drive prices even higher. Traders who anticipate this may buy shares early to capitalize on the upward momentum.
Some investors also use short covering signals to time their own trades. A sudden increase in buying volume on a heavily shorted stock can suggest that short sellers are closing positions, potentially signaling a trend reversal. For long-term investors, short covering can provide entry points when stocks rebound from temporary price dips.
Short covering can significantly impact stock prices and create challenges for both short sellers and other market participants. As it is essentially a risk management tactic, understanding the risks involved helps traders make more informed decisions. Here are five to keep in mind:
Short squeeze risk: If too many short sellers try to cover their positions simultaneously, a stock’s price can surge rapidly. This can lead to mounting losses for those still holding short positions.
Liquidity concerns:Stocks with low trading volume may experience extreme price swings during short covering, making it difficult for traders to exit their positions at a desirable price.
Margin calls: When a stock’s price rises unexpectedly, brokers may require short sellers to deposit additional funds or close positions at a loss, forcing unwanted trades.
Market volatility: Short covering can contribute to sudden price fluctuations, making it harder for investors to gauge a stock’s fair value.
Opportunity cost: Traders covering short positions prematurely may miss out on further declines, reducing potential profits from their original strategy.
An investor reviewing an investment strategy in his apartment.
Short covering can play a significant role in market dynamics, influencing price movements and creating both risks and opportunities for investors. While short sellers aim to profit from declining stock prices, the need to buy back shares can lead to sharp rallies, especially during short squeezes. Traders who monitor short interest and buying activity can use this information to anticipate volatility and adjust their strategies. However, the unpredictability of short covering means it carries potential downsides, including sudden price swings and forced liquidations.
A financial advisor can help you manage risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Investors pursuing risky strategies such as short selling can benefit from having a portion of their portfolio in low-risk savings accounts. SmartAsset’s savings calculator tells you the future value of your savings based on the current annual percentage yield.
