Short Covering

Also known as Purchasing To Cover, is when a buyer invests stock in closing out a sell order that has already been opened. It's one of the investing strategies followed by traders/investors in financial markets.

Author: Elliot Meade
Elliot Meade
Elliot Meade
Private Equity | Investment Banking

Elliot currently works as a Private Equity Associate at Greenridge Investment Partners, a middle market fund based in Austin, TX. He was previously an Analyst in Piper Jaffray's Leveraged Finance group, working across all industry verticals on LBOs, acquisition financings, refinancings, and recapitalizations. Prior to Piper Jaffray, he spent 2 years at Citi in the Leveraged Finance Credit Portfolio group focused on origination and ongoing credit monitoring of outstanding loans and was also a member of the Columbia recruiting committee for the Investment Banking Division for incoming summer and full-time analysts.

Elliot has a Bachelor of Arts in Business Management from Columbia University.

Reviewed By: Patrick Curtis
Patrick Curtis
Patrick Curtis
Private Equity | Investment Banking

Prior to becoming our CEO & Founder at Wall Street Oasis, Patrick spent three years as a Private Equity Associate for Tailwind Capital in New York and two years as an Investment Banking Analyst at Rothschild.

Patrick has an MBA in Entrepreneurial Management from The Wharton School and a BA in Economics from Williams College.

Last Updated:January 4, 2024

What is Short Covering?

Short covering, also known as purchasing to cover, is when a buyer invests stock in closing out a sell order that has already been opened. It's one of the investing strategies followed by traders/investors in financial markets.

As soon as the investor returns the shares he shorted to the borrowing firm, the short sale covering transaction is completed.

For example, a trader is bearish on a stock and expects it to fall; for the same reasons, he sells short ten shares of Apple Inc. at $150. Then, after some time, when Apple Inc. declines and falls to $135, he buys back to cover his initial short position. Therefore booking a profit of $15 on the transaction.

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. 

Once the shares are delivered, the transaction is over, and the short seller has no further duty to the stockbroker. 

Traders purchase to cover their short positions for a variety of reasons. For example, if the price of a stock falls as predicted by short sellers, the company's shares can be acquired for less than the trader pays the Brokerage for the borrowed shares. In this case, covering the short ensures the trader a profit. 

Short sellers understand that shorting a stock exposes them to endless losses since their downside risk is equivalent to the hypothetically unlimited upside of the stock price. When the price of a stock rises, traders may cover their short bets to reduce their losses.

Key Takeaways

  • Purchasing back shares acquired to sell short using the purchase to cover orders is known as short covering, with the ultimate goal being closing off a short position.
  • Short covering is generally required when there is a short squeeze, and sellers are exposed to margin calls. In addition, short-term interest rates can assist in anticipating the likelihood of a squeeze.
  • Open interest is used to cover market scenarios and provide the basis for the origin of shorting stock transactions.
  • The transaction is completed after the investor returns the shares to the broker.
  • Either profit or loss is booked in the transaction, depending upon the repurchase price of the asset.

Understanding Short Covering

It is generally used for your short position, i.e., when you are bearish on a stock. If it's settled at a price lower than the initial purchase price, it's a profitable trade; otherwise, it's a loss when settled at a price higher than the initial purchase price.

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. 

The original stock brokers that issued the securities may also choose to issue margin calls, in which all borrowed shares must be returned immediately. This raises the number of investors seeking to cover their short positions, perhaps leading to greater gains in the company's share price.

Inadvertent short cover can also occur when a company with considerable short interest is exposed to a "buy-in." Stocks with less liquidity, i.e., not enough stocks available for sale/purchase in markets, sometimes lead to closing the position, which is known as short covering.

Generally, to square off open short positions, investors must purchase shares and deliver them to their brokers to settle the transaction, which leads to buy-side demand for the stock and increases the price.

Short Covering Example

For example, Due to losing revenues because of the increased reach of digital distribution platforms, the stock of GameStop(NYSE) was a falling knife. Hence, most investors were bearish on this stock.

As players preferred downloading games instead of buying them at local stores, the corporation's sales took a hit, and new strategies for increasing sales/channels were difficult.

In early 2021, around 60 million GameStop stock was sold short, despite the business having only 50 million outstanding shares.

GameStop's business forecast exceeded expectations, along with coordinated buying by Reddit forum users, prompting the stock to rise dramatically. As a result, many additional investors clamored to cover their shorts, including investment companies with big short holdings. 

GameStop Investors earned decent returns as the stock's price surged by approximately 1,700% in less than a month.

However, the GameStop example demonstrates the danger of presuming that short covering is always easy and how failing to cover a short position may result in significant losses.

A short squeeze can result from too much short covering. A short squeeze happens when many traders have an unfavorable view of a company and choose to sell its shares short. 

Naked short selling permits investors to sell unborrowed short shares, allowing the number of shares sold short to surpass the company's actual share count.

A decrease in open interest and an increase in share price are general indicators to identify a potential short-covering position if needed.

Open interest refers to the total number of outstanding contracts that still need to be settled. It's used as an indicator to determine market sentiments and the strength behind price trends.

Open interest signifies the state of financial markets. Increasing open interest signals additional funds flowing into markets while declining open interest signals a weak market condition. Prevailing market prices take a cue from the increasing/decreasing of open interest and move similarly.

Researched and authored by Arshnoor Kamboj | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: