WHAT IS SHORT COVERING?
Short covering refers to buying back borrowed securities in order to close open short positions at a profit or loss. It requires the purchase of the same security that was initially sold short, since the process involved borrowing the security and selling it in the market. For example, a trader sells short 100 contracts of EURUSD at 1.11465, based on the opinion that the pair will head lower. When the EURUSD declines to 1.11380, the trader buys back the pair in order to cover the short position, booking a profit from the sale. This process is also known as “buy to cover.”
How Does Short Covering Work?
Short covering is necessary in order to close an open short position. A short position will be profitable if it is covered at a lower price than the initial transaction and will incur a loss if it is covered at a higher price than the initial transaction. When there is a great deal of short covering occurring in a pair, it may result in a short squeeze, wherein short sellers are forced to liquidate positions at progressively higher prices.
Short covering can also occur involuntarily when a stock with very high short interest is subjected to a “buy-in”. This term refers to the closing of a short position by a broker-dealer when the stock is extremely difficult to borrow and lenders are demanding it back. Often times, this occurs in stocks that are less liquid with fewer shareholders.
The higher the short interest and short interest ratio, the greater the risk that short covering may occur in a disorderly fashion. Short covering is generally responsible for the initial stages of a rally after a prolonged bear market or a protracted decline in a stock or other security. Short sellers usually have shorter-term holding periods than investors with long positions, due to the risk of runaway losses in a strong uptrend. As a result, short sellers are generally quick to cover short sales on signs of a turnaround in market sentiment or a security's bad fortunes.
- Short interest refers to the number of shares sold short as a percentage of total shares outstanding.
- The short interest ratio (SIR) is computed as total shares sold short, divided by the security’s average daily trading volume.
- The risk of short covering, i.e. whether or not the security will be subject to a short squeeze, can be gauged by short interest and the SIR.
January 5, 2020