What Is Short Covering?

Buying back borrowed securities to terminate an open short position at a profit or loss is known as “short covering.” It necessitates returning the shares borrowed initially for the short sale and buying the identical security that was previously sold short. We call this kind of transaction “buy-to-cover.”

For instance, a trader who believes that XYZ shares will decline sells 100 shares short for $20. The trader books a $500 profit on the sale of XYZ and repurchases it to cover the short position if it drops below $15.

How Does Short Covering Work?

To terminate an open short position, short covering is required. If a short position is covered at a price lower than the original transaction, it will benefit; if it is covered at a price higher than the initial transaction, it will lose money. A short squeeze may happen when a security has a lot of short covering. In this scenario, short sellers lose money and are compelled to liquidate their holdings at higher prices due to their brokers invoking margin calls.

Involuntarily, short covering may also happen when a stock has a “buy-in” from many short sellers. When a broker-dealer closes a short position because it is tough to borrow the stock and lenders request it be returned, this is known as the term. This usually happens to stocks that have fewer owners and are less liquid.

Keeping an Eye on Short Interest

When the short interest and short interest ratio (SIR) are higher, there is a more significant chance of chaotic short covering.

Short covering frequently contributes to the early stages of a rebound following an extended bear market or an extended loss in a stock or other investment. Short sellers often keep their investments for shorter periods than long-term investors because they incur the danger of suffering rapid losses during a substantial rise. Because of this, short sellers often cover short sales quickly when there are indications of a change in the market’s mood or a security’s negative performance.

An Illustration of Brief Coverage

Traders must purchase back the shares and return them to the stock lender to close off a short position, a process known as “short covering.” XYZ has an average daily trading volume (ADTV) of one million shares, 50 million shares outstanding, and 10 million shares sold short. XYZ has a 20% short interest rate and a 10 SIR, which are both relatively high and indicate that short covering would be challenging.

Over a few weeks, XYZ loses territory, which prompts traders to start placing short bets on the company. The corporation releases a significant upward adjustment to its quarterly profits the morning before it opens. At the opening bell, XYZ gaps higher, significantly losing traders’ positions. While some short sellers hold off on covering until a more advantageous price, others want to liquidate their holdings quickly. The price of XYZ shares spikes sharply due to this disorganized short covering, starting a feedback cycle until the short squeeze runs out of steam. Delaying short covering exposes traders to the possibility of buying back the shares at ever-increasing prices, increasing their risk exposure.

The Short Squeeze GameStop

When investors who have borrowed shares to sell with the hope of purchasing them back at a lower price—a strategy known as shorting a stock—are compelled to purchase those shares back at a higher price to minimize their losses, this is known as a short squeeze. It causes the stock to suddenly become more in demand, prompting investors to repurchase shares, raising the price even more swiftly. In January 2021, a meme stock buying frenzy caused a brief squeeze in the physical video game store GameStop, which resulted in significant losses for several hedge funds.

Due to the transition to internet gaming and dwindling revenues, many well-known funds have amassed a sizeable short position in GameStop. Upon seeing the elevated degree of short interest in the company, individual traders collaborated via the WallStreetBets Reddit trading community to elevate the stock price by purchasing shares and options contracts. The stock price of GameStop started to rise quickly as additional investors poured money into the company, which resulted in significant losses for some of the hedge funds holding short positions. Some of these funds started repurchasing shares at a far higher price than they had initially been sold for to lower risk and guard against additional price increases.

In January 2021, institutional investors lost around $19 billion when they shorted GameStop, according to information that Business Insider reported.

Several hedge funds shorted more shares than the market could accommodate, making it impossible to cover all their short positions and intensifying the squeeze.

The stock price increased due to the tremendous demand to buy back shares at any price. GameStop shares continued to rise due to institutional investors’ short coverage of the frantic purchase by retailer traders. In the end, the pressure cost some hedge funds billions of dollars, and in a matter of weeks, the stock price shot up from around $20 per share to over $400.

How are short covers operated?

Short covering is the process of purchasing back shares that were initially borrowed and sold to close out a short position that an investor has established. When a stock is shorted, an investor sells shares borrowed from a stock lender on the open market to repurchase the shares when prices have dropped. The investor’s short position results in a profit if the stock falls but a loss if it rises. Increased short covering could cause a short squeeze, resulting in sizable losses.

What Distinguishes the Short Interest Ratio from Short Interest?

The number of shares sold short of a particular security that hasn’t been covered or closed out is known as short interest. Investors use the statistic to gauge their level of pessimism. A ratio of the total shares that a corporation has available for trade or a proportion of the total shares outstanding might be used to show short interest. In contrast, the SIR divides the total shares held short in a company by the average daily trading volume of the firm. Investors use this statistic to calculate the number of days required to cover all short bets in a company.

What Was the Role of Short Covering in the GameStop Short Squeeze?

After seeing a significant degree of short interest in the firm, retail traders coordinated the frantic purchase of GameStop’s shares and options via the WallStreetBets Reddit trading community. A short squeeze in the company resulted from numerous hedge funds that had bet against the videogame retailer being forced to cover their big short bets quickly at a hefty loss due to the heightened rapid purchasing demand. Several funds shorted more shares than the market could accommodate, making it harder to cover all their short positions and intensifying the short squeeze.

Which Dangers Are Present in Short Coverage?

Losses occur to investors who cover a short position at a higher price than they originally shorted the stock. The short covering can set off more purchasing and create a short squeeze in the company, which increases the risk of significant losses as investors rush to repurchase shares at ever-higher prices. Investors should watch a stock’s short interest and SIR before starting a short position to ascertain the possibility of a short squeeze.

The Final Word

Buying back borrowed securities to terminate open short positions is known as “short covering.” Short sellers frequently hold onto their holdings for a shorter period than those holding long ones because there is a chance of a short squeeze due to increased purchasing pressure and short covering. Therefore, to minimize possible losses, short sellers often cover short sales promptly upon a change in market sentiment. The likelihood that short covering may take place unorganized and result in short squeezes increases with a stock’s short interest and SIR. Prominent short positions held by institutional investors may result in huge losses during a stock-buying frenzy, as in the GameStop short squeeze in early 2021.

Conclusion

• The short covering ends a short position by purchasing back the borrowed shares to short-sell a stock.
• A profit (purchased back below the short sale price) or a loss (repurchased above the short sale price) is the outcome of short covering.
• Short covering might force a short squeeze, making sellers vulnerable to margin calls.
• Predicting the likelihood of a squeeze may be accomplished by keeping an eye on variables like short interest and the short interest ratio in a company.
• In response to a social media-fueled purchasing spree at physical video game retailer GameStop, institutional investors had to cover their short holdings.