Definition
Short covering is a trading strategy where an investor purchases shares to close an open short position. This strategy is undertaken when traders believe the price of a security will rise, aiming to prevent potential losses. Essentially, it’s buying back a security that was initially sold short.
Key Takeaways
- Short Covering refers to the purchasing of shares in order to close an open short position. It is an action triggered when the price of an asset seems to surge unpredictably and the short seller needs to limit their potential losses.
- This process involves buying the same amount of stocks that were initially shorted, effectively neutralizing the short position. This is often driven by the fear of a short squeeze or to take profits from a drop in the prices.
- A surge in buying activity during short covering can lead to an accelerated increase in the price of the asset. This scenario often leads to sharp, rapid increases in a particular security’s price, attributable to short sellers trying to cover their positions.
Importance
Short covering is an important finance term because it refers to the buying back of securities that have been sold short in anticipation of a price decline, typically to prevent further loss or to turn a profit.
This activity can increase demand for a security, which can cause its price to rise dramatically.
This process can instigate a short squeeze where increasing prices force short sellers to liquidate their short interests at increasingly higher prices, escalating the price even further.
As a result, understanding short covering is crucial for traders and investors as it can directly impact the financial markets and the pricing of securities.
Explanation
The primary purpose of short covering in finance is to minimize the risk of loss from a short sale if the price of the underlying asset starts to rise. A short sale refers to the selling of an asset that the investor doesn’t own, with the intention of buying it back later at a lower price, making a profit from the difference.
However, if the price of the asset increases instead of falling, the investor would be at a loss. To prevent this, they may decide to close their position through short covering, which involves purchasing the same amount of the said asset at its increased price in order to return it to the lender.
Short covering is also used strategically by traders to manipulate the market or profit from price movements. For instance, if a significant number of short sellers initiate short covering at around the same time, it can trigger a sharp increase in the price of the asset, a phenomenon known as a short squeeze.
Traders who are able to anticipate or trigger such a squeeze can make a profit by purchasing the asset early and selling it at the higher price. Short covering therefore, can be an important strategic tool for traders and can also influence market dynamics.
Examples of Short Covering
Sure, here are three examples of short covering in the real world:GameStop Saga (2021): The most famous recent example of short covering is the GameStop short squeeze in
Hedge funds had heavily shorted GameStop’s shares, betting that its price would continue to fall. However, individual traders on Reddit collectively bought the stock, causing its price to skyrocket. This forced many of the hedge funds to buy back the shares to cover their short positions at much higher prices, creating a short squeeze.Volkswagen Short Squeeze (2008): Another notable case was the Volkswagen short squeeze in
Porsche quietly built a significant stake in Volkswagen, and when they announced their holdings, the stock price surged. Traders who had shorted Volkswagen’s stock had to rush to cover their positions, further driving up the price.Herbalife Short Squeeze (2013): In this case, billionaire investor Bill Ackman revealed a $1 billion short position in Herbalife, a nutritional supplement company, accusing the company of being a pyramid scheme. However, other big investors, like Carl Icahn, disagreed and bought shares of Herbalife. As the price rose, short-sellers had to cover their positions, causing the stock price to rise even further.
FAQs about Short Covering
What is Short Covering?
Short covering refers to the buying of securities to close an open short position. It involves the purchase of the exact same securities that were sold short, to return to the lender and close the short position.
When does Short Covering occur?
Short covering typically occurs when traders or investors perceive that the price of the shorted security may rise in the near future, possibly leading to a loss. Then to avoid further losses, they cover their positions.
What are the impacts of Short Covering on the market?
Short covering can produce a sharp increase in the price of a stock due to increased demand to buy the security. This is usually temporary and is often followed by a decline if the fundamentals of the security are still weak.
What’s the difference between Short Covering and Short Squeeze?
While both Short Covering and Short Squeeze involve buying back borrowed securities, a Short Squeeze is a specific situation where the price of the security increases significantly, forcing the short sellers to cover their positions at a loss. Short Covering, on the other hand, isn’t necessarily related to a sharp price increase and is more a part of regular trading practices.
Related Entrepreneurship Terms
- Margin Call
- Bear Market
- Short Squeeze
- Short Interest
- Buy-to-Cover Order
Sources for More Information
- Investopedia has an extensive glossary of finance terms including short covering.
- MarketWatch provides news, analysis, and insights about financial markets and terms.
- Reuters offers global financial news, market analysis and detailed explanations about various financial terms.
- Bloomberg is a leading source for business and financial market news. It also offers definitions and explanations for financial terms.
