Have you heard the term short coverings in your research to increase your investment portfolio? But not sure what it means or what it's all about. 

Let us help you understand everything you need to know about short coverings, how it works, and what happens when a short squeeze occurs.

What is Short Covering - Table of Contents

What Do You Mean by Short Coverings?

Short coverings refer to the buying back of borrowed securities to close an open short position at profit or loss. This requires the purchase of the same security that was initially sold short and handing over the shares borrowed for the short sale. These transactions are referred to as buy-to-cover. A buy-to-cover relates to the buying orders made on stock and other listed security to close out any existing short position. 

For example, traders sell short 100 shares of ABC at $20 based on the option that the shares will head lower. When ABC declines to $10, the trader will buy back the shares to cover the short position making a profit of $1000 from the sale. 

How Does Short Covering Work?

Short covering is required to close an open short position. This short position is profitable when covered at a lower price than the initial transaction. But it incurs a loss when it covers a higher price than the initial transaction. When a large amount of short covering occurs in security, it results in a short squeeze. In this stage, short sellers are forced to liquidate positions at higher prices as they lose money and brokers invoke margin calls. 

Short coverings can also happen in involuntary situations where a stock with high short interest is subjected to buy-ins. This term refers to closing of a short position by broker-dealers when it is difficult to borrow on stock, and the lenders demand it back. Most times, this occurs when stocks are less liquid and have fewer stockholders. 

What is Short Positioning? 

Investors believe that the price of stocks will fall when it comes to short selling. This is also known as a short position.

What is the Short Positioning Cycle?

1. Opportunity: When investors see an option, the price of a given stock in the market falls. 

2. Opens short position: An investor borrows the company's shares at the current price. 

3. Selling stocks: Investors sell borrowed shares, known as selling shorts. 

4. Waiting period: The incubation period where investors wait for stock prices to drop before closing a short position. 

5. Closing the short position: When the stock price drops, the investor helps buy back the number of borrowed shares. 

6. Revenue: In the previous phase, two things can happen - one, as anticipated, the stock prices may fall. The outcome leads to profits as the trader will exit the short position at a lower level. The difference in the entry and exit incurred is a profit. But if the stock price rises, the traders will incur a loss as they must pay a higher price to repurchase the stocks.

What Happens When a Short Squeeze Occurs? 

A short squeeze happens when multiple traders have a negative outlook about a corporation and chooses to sell its short stock. A practice commonly called naked short selling offers investors to sell short shares that are not borrowed. This can push the number of shares sold short above the corporation's actual share count. When the traders' sentiments change about the company, and multiple investors want to cover up their short sales simultaneously, they put a 'squeeze' on the total number of shares that are readily available for purchasing. This causes the price of that particular stock to increase. 

The original brokerages that lent out the shares can also issue margin calls. This means that all the claims they had loaned must be returned to them immediately. This helps further increase the total number of investors who try to cover their short positions and can cause sharp gains in the corporation's share prices. 

Special Considerations - Short Interest vs Short Interest Ratio (SIR) 

The higher the difference between the short interest and short interest ratio, the bigger the risk that short coverings might occur in a disorderly fashion. Short covering is responsible for the initial stages after a prolonged bear market or in the case of a protracted decline in the stock. Short sellers usually have short-term holding periods that investors with long-term positions due to the risk of runaway losses in a higher uptrend. Because of this, short sellers quickly cover short sales on signs of turnarounds in the current market sentiments or a stock's bad fortunes. 

Example of Short Covering

Let's understand the concept of short covering with an example. 

Multiple traders negatively viewed the video game retailer GameStop as the company was losing sales to the digital channels. In the present world scenario, gamers opt more to download games than buy them from stores. Due to this, the company has been struggling to diversify its sales channels. Roughly 70 million shares of GameStop were sold in 2021, but the company had only 50 million shares. 

Ironically, GameStop's business defied expectations and started improving. Coupled with the coordinated buying by Reddit forum members, the stock prices started increasing significantly. Investment firms had significant short positions, and other investors began clamoring to cover their shorts. Even stock prices increased by over 1700% in less than a month. This enabled GameStop investors to enjoy exceptional gains. But, this example illustrates the risk that investors take in assuming that short covering is always possible and proves that not covering these risks can result in massive losses. 

Conclusion

Now that you know everything about Short Covering, we hope you make suitable investment planning or portfolio-building choices. If you are a novice in this, it is best to get help from the experts. But if you do want to do it yourself, then study about investment plans as much as you can before you jump in.