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Short Covering

What Is Short Covering?

Short covering is the act of closing out a short position in a security. Investors who believe that a stock, bond or commodity is overvalued and is likely to decline in price can try to profit on that belief by selling short that particular asset.

In a short sale, the investor borrows the security from their broker and immediately sells it. At some point the investor has to buy the security back—because it was borrowed—and return it to their original owner. The act of buying the security back is called short covering.

Short sellers "cover their shorts" for either of two reasons:

  • They have made a satisfactory trade by selling the security short and want to cash in their profits by buying back the now lower-priced security
  • The security they thought was about to fall has gone up instead; to avoid further losses, they buy the security back

Short Covering Examples

As an example, an investor believes that ABC Corp. stock is overvalued at US$20 a share. They borrows 1,000 shares from his broker and immediately sells them, giving them US$20,000 in their account, minus whatever fees the broker charges. The stock, as the investor predicted—and hoped—then falls to US$10 a share. Satisfied with that gain, they then buy 1,000 shares for $10,000 and returns them to the broker, walking away with a US$10,000 profit, before fees and charges.

However, if the investor guesses wrong and ABC stock immediately starts to rise, the investor has to decide whether to cut their losses or risk losing a lot of money. Theoretically, the price of any security can rise forever, meaning the short seller's potential losses are unlimited.

For example, let's say the price of ABC rises to US$25 a share. The short seller is now facing a loss of US$5,000, which is the difference between selling the shares for US$20,000 (US$20 X 1,000) and buying them back for US$25,000 (US$25 X 1,000). They elect to cut their losses and buy the stock back at US$25 a share. The act of buying the stock back is called short covering.

Summary

Short covering is the act of buying back shares that have been sold short. An investor can seek to profit from what they believe is an overvalued security by selling it short, or selling borrowed shares, which they then have to buy back at some point. The act of buying them back is called short covering, thus closing the trade.

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