What is short covering? Investing Definitions

what is short covering

Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.

Options trading is ENTIRELY different from trading stocks. I don’t recommend beginning traders start options trading without doing a lot of research beforehand — it can be a complicated game. The goal in stock trading is to buy low and sell high … right? And to catch the hottest news that can drive big market moves and short squeezes, get STT with the game-changing Breaking News Chat add-on for $17. Identifying successful short squeeze plays tends to be difficult, and most investors shouldn’t structure any significant portions of their portfolios around these types of trades. Investors are generally much better served by backing strong companies with favorable business outlooks.

Investors must stay updated on regulatory developments and ensure they comply with all applicable rules and regulations. We’d like to share more about how we work and what drives our day-to-day business. In my 15 years of trading, I don’t think I’ve ever seen so much volatility for this long.

what is short covering

A stock rising in price can also prompt traders to cover their short positions in order to limit their losses. As a result of the shift to online gaming and declining sales, several prominent funds had built a large short position in GameStop. Retail traders noticed this high level of short interest in the stock and worked together through Reddit trading group WallStreetBets to drive up the stock price by buying shares and options contracts. As more investors piled into GameStop, the stock price began to climb rapidly, causing some of the hedge funds with short positions to suffer steep losses. In an attempt to reduce risk, some of these funds began buying back shares at a much higher price than they had initially sold them for to protect against a further rising prices. The squeeze was exacerbated by several hedge funds shorting more shares than the available float of shares in the market, making it nearly impossible to cover all their short positions.

This added immense pressure to buy back shares at any available price, further pushing up the stock price. The frenzied buying by retailer traders resulted in short covering by institutional investors, creating a feedback loop that kept pushing GameStop shares higher. Ultimately, the squeeze caused some hedge funds to lose billions of dollars, and the stock price to rise from around $20 per share to over $400 in just a few weeks. XYZ loses ground over several weeks, spurring traders to open short positions in the stock. One morning before they open, the company announces a major upward revision in quarterly earnings.

However, the security being sold may not always drop in price. If the security’s price increases, the investor may issue a buy to cover to prevent future losses on the short position. Furthermore, short covering can also be influenced by short squeeze risks.

If market sentiment shifts and too many investors seek to cover their short sells simultaneously, the number of shares available for purchase may be “squeezed,” causing the stock price to rise. When an investor sells a share that they do not own, this is known as selling the stock short. Short selling is a wager that the price of a stock will fall. Short Covering is a method of exiting a short position by purchasing the borrowed shares and returning them to the loan company.

How we use your personal data

Institutional investors lost roughly $19 billion short selling GameStop in January 2021, according to data cited by Business Insider. Investors may consider technical analysis indicators, such as trend reversals or https://www.topforexnews.org/ price patterns, to identify potential inflection points for short covering. Increasing open interest signals additional funds flowing into markets while declining open interest signals a weak market condition.

As a result, they may rush to opt out of the short position by buying back the stock. However, the more they buy, the more the stock price rises. GameStop’s business outlook defied expectations by improving, and this, coupled with coordinated buying among Reddit forum members, caused the stock’s price to begin to significantly increase. The investment firms with large short positions, among many other investors, clamored to cover their shorts. The stock’s price increased by nearly 1,700% in less than a month, enabling investors who owned GameStop stock outright to enjoy incredible gains.

Too much short covering can cause a short squeeze

XYZ gaps higher at the opening bell, placing traders’ positions into a significant loss. Some decide to wait for a more favorable price and hold off on covering, while other short sellers exit their positions aggressively. This disorderly short covering causes a sharp spike in the XYZ share price, creating a feedback loop that continues until the short squeeze exhausts itself. Traders who delayed short covering risk having to buy back the shares at a higher and higher prices, exposing themselves to greater risk.

Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. Our goal is to deliver the most understandable and comprehensive explanations of financial topics using simple writing complemented by helpful graphics and animation videos.

  1. As more investors piled into GameStop, the stock price began to climb rapidly, causing some of the hedge funds with short positions to suffer steep losses.
  2. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.
  3. We’d like to share more about how we work and what drives our day-to-day business.

That’s why short sellers rush to buy back shares when a stock begins to surge. In short selling, it’s especially important to craft a well-thought-out trading plan and stick to it. Short selling is a lot riskier than opening a long position — there’s much more to lose. Sticking to a solid trading plan can help you limit your losses. A squeeze happens when several short sellers are stopped out at the same time. Short covering refers to the process of closing out a short position in a financial instrument.

According to the math, Joe will generate a revenue of $10,000 ($30,000 – $20,000). He sold his borrowed stocks at $30,000 (1,000 shares x $30) and bought them at $20,000 (1,000 shares x $20,000). Short covering refers to buying back borrowed securities in order to close out an open short position at a profit or loss. It requires purchasing the https://www.dowjonesanalysis.com/ same security that was initially sold short, and handing back the shares initially borrowed for the short sale. Short covering impacts market sentiment, stock prices, and portfolio management. It provides insights into market dynamics, helps manage risk, and allows investors to adjust their portfolios based on changing market conditions.

Let us understand this with the help of an example.

Investors engaging in short selling must adhere to applicable regulations and disclose their short positions as required by regulatory authorities. In such cases, the short seller is required to deposit additional funds or securities to meet the margin requirements. Failure to meet margin calls can result in forced liquidation of the short position, potentially locking in losses. By evaluating various factors, investors can make informed decisions on when to cover their short positions to maximize potential profits or minimize losses. Regulatory changes and policy developments can have a profound impact on short covering. New regulations or policy shifts that affect short selling activities or impose restrictions can influence short sellers’ behavior.

Short covering plays a crucial role in portfolio management, particularly for investors who engage in short selling or have exposure to short positions. Naked short selling permits investors to sell unborrowed short shares, allowing the number of shares https://www.forexbox.info/ sold short to surpass the company’s actual share count. Risks in short covering include potential losses, margin calls, liquidity risks, and compliance considerations. Investors need to manage these risks effectively to mitigate potential downsides.

How to apply stop-loss on the short position?

In this case, covering the short ensures the trader a profit. Retail traders noticed a high level of short interest in GameStop and worked together through Reddit trading group WallStreetBets to coordinate frenzied buying in the company’s shares and options. The short squeeze was exacerbated by several funds shorting more shares than the available float of shares in the market, making it difficult to cover all their short positions. Short covering works by closing out a short position that an investor has made by buying back shares that were initially borrowed and sold.