Short covering: meaning, examples and how it works
The term “short covering” refers to the process of finding the right time to buy back borrowed securities. Here we explain more about this trading strategy and how it works.
IN A FEW WORDS
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4 min reading
When short selling, it is crucial to choose the right time to buy back borrowed securities. This transaction is referred to as short covering. It is also known as buying to cover, that is buying stock to cover and close open short positions.
In trading, short selling is popular among investors as it allows you to profit from a security’s fall in price. However, to make a success of short selling, it’s important to understand the process of short covering. Let’s look at that process with some examples to understand how it works.
What is short covering?
Short covering means the covering of a short position to close a previously opened short trade. With short covering the trader fulfils their obligation to the lender of the securities by returning the securities to conclude the short-selling transaction at either a profit or a loss, depending on the circumstances.
In brief, when you open a short sale, you borrow securities from the lender and then resell them at the market price. If the value of the asset falls, the trader buys back the securities at a lower price to return them to the owner and make a profit. If, on the other hand, the value of the asset goes up, the trader may be forced to close their position to limit losses.
Short covering describes the repurchase of the borrowed securities and their return to the lender. Choosing when to buy to cover is a complex process, and it’s essential to have a strategy to follow to manage your risks.
How does short covering stocks work?
A trader's goal is to profit from short selling, so they expect the price of the securities to fall enough to make a profit in line with expectations, and before they must buy to cover.
However, things don’t always work out. The price of the shares sold short may not fall as expected, as happened to the hedge funds that shorted GameStop shares. In that case the price went up because of massive purchases by retail traders, but this could also happen because of a valuation error or an unexpected recovery of a listed company.
Whatever happens, when conditions arise that make it attractive to close an open short position, it’s essential that you contact your broker to give the order to buy the securities at the market price. The broker will then try to buy back the securities at the best possible price, after which you just need to return them to the holder.
In some cases, when the price of the securities goes up instead of down, your broker may require your position to be closed or ask for a deposit to keep the trade open. In this latter situation, you can choose what to do: whether to deposit the amount requested and continue short selling or buy back the securities immediately and limit losses.
An example of short covering in stocks
Typically, short selling of stocks happens in companies that are going through a bad patch, for example, because their business model no longer works or they have poor management. Or they might have tricked the market, showing that they are healthy and growing by rigging their balance sheet figures in some way.
Let’s look at an example to better understand how short covering works. Let’s imagine that we’re shorting Apple shares, anticipating that the company may go into a crisis and reduce its market price in the coming months. The trader borrows 100 Apple shares at a price of £120, investing £12,000. At this point, the trader sells the 100 Apple shares on the market and gets £12,000, knowing that they will have to return those shares to the lender later.
After a month, Apple's share price falls to £80, so the trader decides to short cover at this point, buying back the 100 Apple shares on the market for a total of £8,000, returning them to the owner and making a profit of £4,000.
If Apple's share price rises instead, say to £150, the broker may ask the trader to make a deposit to keep the position open or to close the trade. If the trader thinks that Apple's stock will not go down or doesn’t want to risk further losses, they buy back the 100 shares at a cost of £15,000, making a loss of £3,000.
Typically, short covering of shares takes place in the short term, as short sellers have to be very careful of upward trends, unlike investors with long positions. Usually, at the first sign of a change in market sentiment, short sellers immediately resort to buying to cover to ensure profit. Timeliness is essential, as any delay in short covering could wipe out all the gains made so far or even cause a loss if the securities to be returned cannot be bought back quickly.
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