What Is Short Covering?
Short covering refers to the practice of buying back borrowed securities in order to close out an open short position, which can result in a profit or loss. It involves purchasing the same security that was initially sold short and returning the borrowed shares to the lender. This transaction is commonly known as ‘buy to cover’.
For example, a trader sells short 100 shares of XYZ at $20, predicting the price will drop. If XYZ’s price falls to $15, the trader buys back the shares to cover their short position, earning a $500 profit.
Key Takeaways
- Short covering terminates a short position by acquiring the shares initially borrowed for a short sale.
- It leads to a profit if covered at a lower price than the short sale price, or a loss if covered at a higher price.
- Excessive short covering can provoke a short squeeze, where sellers face margin calls.
- Monitoring metrics like short interest and short interest ratio can help predict short squeezes.
- A social media-driven buying frenzy in GameStop led to significant short covering and heavy losses for big institutional investors.
How Does Short Covering Work?
Short covering is essential to close an open short position. It’s profitable when covered at a price lower than the initial sale and results in a loss if covered at a price higher than the initial sale. A surge in short covering within a security can lead to a short squeeze, where short sellers face significant losses and are forced to cover at increasingly higher prices due to margin calls.
In some cases, short covering may happen involuntarily in what’s termed a ‘buy-in’. This takes place when a stock with substantial short interest becomes extremely difficult to borrow, forcing brokers to close out short positions due to lender demands. This is more common in less liquid stocks with limited shareholders.
Monitoring Short Interest
A high level of short interest and short interest ratio increases the risk of disorderly short covering. These events often fuel the early stages of a rally after prolonged bear markets or extended declines in a particular security. Short sellers tend to have shorter holding periods and may cover their positions quickly in response to a market sentiment shift or specific security’s improvement.
Example of Short Covering
Imagine XYZ has 50 million shares outstanding, with 10 million shares short-sold and an average daily trading volume of 1 million shares. This reflects a short interest of 20% and a short interest ratio (SIR) of 10, each indicating potential difficulty in covering short positions.
After XYZ shares fall, more traders short the stock. Before market opening, XYZ announces a robust earnings revision, causing its stock to gap up in price. Some traders cover their positions quickly while others hold off, leading to chaotic short covering and a sharp price increase until the squeeze peaks.
The GameStop Short Squeeze
A short squeeze occurs when short sellers are compelled to buy back stocks at higher prices due to mounting losses. In January 2021, a coordinated buying spree orchestrated by the Reddit group WallStreetBets targeted GameStop, leading to a dramatic short squeeze.
Hedge funds that had bet against GameStop saw significant losses as they scrambled to cover their positions. The stock, which began at around $20, surged to over $400 in a matter of weeks. Large funds lost billions, all triggered by amplified short covering due to excessive short interest.
What’s the Difference Between Short Interest and the Short Interest Ratio?
- Short Interest: Reflects the total number of shares sold short but not yet covered. It’s a measure of bearish sentiment and can be presented as a percentage of the total outstanding shares or based on the float.
- Short Interest Ratio (SIR): Equates the number of shorted shares to the average daily trading volume, indicating how many days would be needed to cover all short positions in the stock.
Risks Associated with Short Covering
Short covering at higher prices results in losses. This activity can trigger further share purchases, possibly creating a short squeeze and considerably increasing potential losses. Investors should carefully monitor short interest and SIR before initiating short sales to evaluate the risk of a short squeeze.
The Bottom Line
Short covering is buying back borrowed securities to close out short positions. Just as investors with long positions aim for profits, short sellers aim to buy back at lower prices than the sell prices. Large volumes of short interest and SIR increase the possibility of a short squeeze. Monitoring stock metrics can reduce risk, as illustrated by significant institutional losses during the GameStop short squeeze.
Related Terms: short interest, short squeeze, buy-to-cover, margin calls, short interest ratio.
References
- Investor.gov. “Stock Purchases and Sales: Long and Short.”
- FINRA. “Short Interest - What it is, What it is Not.”
- The New York Times. “Melvin Capital, Hedge Fund Torpedoed by the GameStop Frenzy, is Shutting Down.”
- Business Insider. “Short-Sellers are Nursing Estimated Losses of $19 Billion in 2021 After Betting on GameStop’s Share Price to Fall.”
- Reuters. “Explainer: How Were More Than 100% of GameStop’s Shares Shorted?”
