What is Short Covering?

Last Updated: 10 Jan 2025

In the financial markets, leverage is used extensively to increase the potential return on investment. Leverage involves using borrowed capital or securities to fund a financial asset. Short selling and covering are strategies that incorporate leverage to maximize returns.

What Is Short Covering in Share Market?

To understand Short Covering, it is important to touch base on short selling. The concept of Short Selling refers to a transaction where a trader borrows a security and sells it in the open market intending to repurchase it at a lower price. Typically, a short sell transaction is executed when a trader expects the price of the security to fall in the short term. Short selling is also referred to as short positioning.

Short covering means the purchase of a security to close out an open short position in the market at a profit or a loss. Short covering in stocks entails purchasing the security that was short sold and simultaneously returning the securities which were originally borrowed.

How does Short Covering Work?

Short covering is the process by which an investor buys back the same amount of a security that was previously borrowed and sold short. Essentially, it involves closing out a short position to mitigate potential losses or capitalize on gains. Here’s a step-by-step explanation of how short covering works:

1. Short Selling: To understand what is short covering, first, it’s crucial to grasp short selling. Investors who short-sell borrow shares from a broker and sell them on the open market, hoping to buy them back at a lower price in the future. The aim is to profit from the decline in the stock’s price.

2. Market Movement: After short selling, the market price of the stock can either decrease or increase. If the stock’s price decreases, the short seller stands to make a profit by buying back the shares at a lower price. However, if the stock price rises, the short seller incurs a loss.

3. Initiating Short Covering: Short covering means repurchasing the borrowed shares to close out the short position. This is often triggered when the short seller anticipates further upward movement in the stock’s price, leading to potential losses.

4. Placing a Buy Order: To initiate short covering, the investor places a buy order for the same amount of shares that were initially short-sold. The objective is to return the borrowed shares to the broker.

5. Closing the Position: Once the buy order is executed, the investor returns the shares to the broker, effectively closing out the short position. This process completes the short covering.

6. Market Impact: When many short sellers initiate short covering simultaneously, it can lead to a rapid increase in the stock’s price, known as a “short squeeze.” This occurs because the demand for the stock rises significantly due to the need to repurchase shares.

Short covering means repurchasing borrowed shares to close a short position, usually in response to rising stock prices. It is done to limit losses or secure profits. Understanding what is short covering is essential for investors engaged in short-selling strategies.

Features Of Short Covering

• Opportunity –The trader is bearish and expects a fall in the price of the underlying asset.
• Short Position –The trader has borrowed shares and sold them for a lower price. In this case, the profit potential is limited whereas the risk is unlimited.
• Waiting Period – The waiting period refers to the time required for the market price of the underlying security to fall. The trader must wait for the stock price to drop to close the short position.
• Short Covering – Once the price of the security falls, the trader buys back the exact number of shares that were initially borrowed.
• Revenue – Since the price movement is per expectation, the trader earns a profit from the transaction. Covering the short locks in the profit for the trader.

For example, the shares of ITC Limited are trading at Rs. 230. A government announcement is expected which may lead to an increase in the tax liability for ITC Limited. You expect the price to fall and borrow 1000 shares of ITC Limited at Rs. 230 and sell them at the current market price of Rs. 230.

Within a few weeks, the price of ITC Limited is Rs. 210 and so you purchase the shares at the prevailing market price of Rs. 210. Hence, the gain from the transaction is the difference between the purchase and selling price of the borrowed stock. In this case, you earn a profit of Rs. 20 per share and an overall profit of Rs. 20,000 from the transaction.

In a short sell position, if the price of the underlying security rises then a trader may be forced to short cover to avoid loss. As a result, traders may rush to opt out of the short position by buying back the stock.

In the above example, let’s suppose the price of ITC Limited rises to Rs. 250. In this case, you may rush to close the position to avoid further loss. The loss on such a sale is Rs. 20 per share with an overall loss of Rs. 20,000 from the transaction.

Too much short covering can cause a short squeeze

A short squeeze primarily occurs when the stock price of the underlying asset does not move in line with expectations. Too many traders rush in to cover their short sale and that can put a ‘squeeze’ on the number of shares available for purchase. Ultimately, the demand for the shares is so high that the price increases significantly.

Additionally, the intermediaries who lent the shares may decide to issue margin calls. Margin calls indicate that the shares loaned are to be returned immediately. This may also lead to an increase in the number of traders trying to cover their position and the price of the underlying security.

Special Considerations

Short Interest and Short Interest Ratio are two important parameters to assess the risk involved with short covering in the share market. Short interest and short interest ratio are directly proportional to the risk of short covering occurrence in a disorganized manner.

The holding period for short sellers is comparatively lower than for the traders with a long position. The reason being short-sellers are potentially exposed to unlimited loss in case of a strong uptrend. Hence, short-sellers are prompt to cover short sales in case of a change in market sentiment.

Generally, short covering in stocks is responsible for the initial increase in price after a persistent bear trend or drastic fall in prices of the security. Identifying a short squeeze tends to be difficult and traders must be careful not to structure a sizable portion of their portfolio to such trades.

Short covering is an interesting trading opportunity to not only profit from the fall in prices but also close out an open short sell position.

Example of Short Covering

To comprehend the concept of short covering, consider the following example. Imagine a trader, Alex, who expects the stock price of Company X to decline. Acting on this belief, Alex shorts 100 shares of Company X at ₹500 per share, to buy them back at a lower price later.

Short covering refers to the process of repurchasing the previously shorted shares to close out an open short position. In this scenario, suppose Company X announces unexpectedly strong quarterly earnings, causing the stock price to rise to ₹550 per share. Alex, recognizing the potential for further price increases, decides to execute short covering to mitigate losses.

So, what is short covering in practice? Alex buys back the 100 shares of Company X at ₹550 each to close the short position. This action, known as short covering, results in a loss of ₹50 per share, totalling a ₹5,000 loss. However, short covering means that Alex has now closed the open short position, thereby avoiding even greater potential losses if the stock price continues to rise.

Thus, what is short covering’s impact on the market? When multiple traders engage in short covering, it can lead to a sharp increase in stock prices. This occurs because the act of buying shares to cover shorts adds buying pressure to the market, often exacerbating price movements.

Short covering means traders are repurchasing shares they had initially sold short to close out their positions. By understanding what is short covering, traders can better manage their strategies and respond to market movements effectively. This process can significantly influence stock prices, particularly when multiple traders simultaneously engage in short covering.

Frequently Asked Questions

Does short selling have a time limit?

There is no time limit on the period for which a short sell transaction can be open. By default, a short sale is held indefinitely.

Is short selling legal?

In India, the restrictions on short selling have been considerably lifted. However, investors are required to honour their delivery obligation within the specified time.

Is short covering bullish or bearish?

Short covering means the act of buying back borrowed shares to close a short position. It is generally considered bullish as it indicates an upward pressure on stock prices due to increased buying activity.

What is short covering in F&O?

Short covering in F&O refers to the buying of contracts to offset a previously established short position. This results in upward price movements and can lead to a short squeeze if many traders cover simultaneously.

Does short covering increase stock prices?

Yes, short covering can increase stock prices. The buying back of borrowed shares leads to increased demand, which can drive the stock prices higher. This is especially true if many short sellers cover their positions simultaneously.