Short Covering Definition

By JAMES CHEN

Updated Apr 8, 2020

What Is Short Covering?

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 same security that was initially sold short,
and handing back the shares initially borrowed for the short sale. This type of transaction is
referred to as buy to cover.

For example, a trader sells short 100 shares of XYZ at $20, based on the opinion those shares
will head lower. When XYZ declines to $15, the trader buys back XYZ to cover the short
position, booking a $500 profit from the sale. This process is also known as “buy to cover.”

KEY TAKEAWAYS

 Short covering is closing out a short position by buying back shares that were initially borrowed
to sell short using buy to cover orders.
 Short covering can result in either a profit (if the asset is repurchased lower than where it was
sold) or for a loss (if it is higher).
 Short covering may be forced if there is a short squeeze and sellers become subject to margin
calls. Measures of short interest can help predict the chances of a squeeze.
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Short Covering
How Does Short Covering Work?
Short covering is necessary in order to close an open short position. A short position will be
profitable if it is covered at a lower price than the initial transaction and will incur a loss if it is
covered at a higher price than the initial transaction. When there is a great deal of short covering
occurring in a security, it may result in a short squeeze, wherein short sellers are forced
to liquidate positions at progressively higher prices as they lose money and their brokers
invoke margin calls.

Short covering can also occur involuntarily when a stock with very high short interest is
subjected to a “buy-in”. This term refers to the closing of a short position by a broker-dealer
when the stock is extremely difficult to borrow and lenders are demanding it back. Often times,
this occurs in stocks that are less liquid with fewer shareholders.

Short Interest and Covering Shorts

The higher the short interest and short interest ratio (SIR), the greater the risk that short covering
may occur in a disorderly fashion. Short covering is generally responsible for the initial stages of
a rally after a prolonged bear market or a protracted decline in a stock or other security. Short
sellers usually have shorter-term holding periods than investors with long positions, due to the
risk of runaway losses in a strong uptrend. As a result, short sellers are generally quick to cover
short sales on signs of a turnaround in market sentiment or a security's bad fortunes.

Example of Short Covering

Consider that XYZ has 50 million shares outstanding, 10 million shares sold short and average
daily trading volume of 1 million shares. XYZ has short interest of 20% and a SIR of 10, both of
which are quite high, suggesting that short covering could be difficult.

XYZ loses ground over a number or days or weeks, encouraging even greater short selling. One
morning before the open they announce a major client that will greatly increase quarterly
income. XYZ gaps higher at the opening bell, reducing short seller profits or adding to losses.
Some short sellers want to exit at a more favorable price and hold off on covering while other
short sellers exit positions aggressively. This disorderly short covering forces XYZ to head
higher in a feedback loop that continues until the short squeeze is exhausted while short sellers
waiting for a beneficial reversal incur even higher losses.

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Related Terms

What Does Short-Interest Theory Mean?

Short-interest theory states that high levels of short interest are a bullish
indicator. Its proponents will therefore seek to buy heavily shorted stocks.

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Bear Squeeze Definition

A bear squeeze is a situation where sellers are forced to cover their positions as
prices suddenly ratchet higher, adding to the bullish momentum.

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Short Squeeze and Example

A short squeeze is when a heavily shorted security moves sharply higher, forcing
short sellers to close out their positions and add to the upward pressure. Short
sellers need to be aware of squeezes, as buyers look to profit from them.

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Short Selling

Short selling occurs when an investor borrows a security, sells it on the open
market, and expects to buy it back later for less money.

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Days To Cover Definition

Days to cover, also called short ratio, measures the expected number of days to
close out a company's issued shares that have been shorted.

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Short (Short Position) Definition

Short, or shorting, refers to selling a security first and buying it back later, with
the anticipation that the price will drop and a profit can be made.

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