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All you wanted to know about short covering

Yoganand D | Updated on: Feb 04, 2019

Whenever an individual stock or the market as a whole rebounds suddenly after declining for a long time, market mavens attribute it to short-covering. ‘Short covering’ also hogs the headlines every time the market faces the expiry of monthly derivative contracts.

What is it?

In the stock markets, when an investor or trader thinks that a stock is going to tank, he or she may sell the stock at the current price in the hope of buying it back at a lower price after it falls. This helps the trader pocket quick profits. Often, the trader may decide to sell a stock he/she doesn’t actually own. In such cases, he/she borrows the security from other market players to execute this trade.

Short-covering is the practice of buying back the security that one has sold earlier to cover an open position. A trader purchases the same number and type of securities as he/she initially sold, to make good the open position. The term is usually employed in the derivatives markets.

Think of a smart equity trader who has been in the stock market long enough to understand the way it works. While tracking ABC stock, he believes that the stock is over-valued and likely to decline. He initiates a short position on 100 shares of ABC at ₹170, in anticipation that the ABC stock will decline to ₹150. He borrows 100 shares from a friend and sells them at ₹170. Or he sells the stock future in the derivative market.

After shorting, the trader observes what happens to the stock. If his call was right and the stock declines thereafter to ₹150 levels, he buys it back from the market at ₹150 to close his trade, earning him a profit of ₹2,000 (₹17,000-₹15,000). The second leg of this trade is short-covering.

However, short-covering may be necessary even if the stock rises instead of falling, and the trader wants to square off his position.

Why is it important?

A majority of investors in the stock market look to make money by buying shares of companies with good prospects and hanging on to them in the hope of the price rising. But such investors get to earn returns only when the market is heading up. Short-sellers are a rarer category of investors who profit when stock markets are in a bear grip. Short-sellers thus play an important role in helping price discovery by acting as counter-parties to buyers of stocks and stock futures. Short selling plays an important role in correcting stock prices and valuations in over-heated markets by preventing continuous one-way moves.

Why should I care?

Short-selling and short-covering are often at the root of big market swings that may appear puzzling to lay investors. For instance, during the derivatives expiry session on January 31 before this interim Budget, many traders covered their short positions initiated a few days ago, to be on the safe side ahead of the big event, causing a spike in the index. Recently, the stock of Maruti tumbled more than 7 per cent after its Q3 earnings turned out lower than market expectation. Traders took this opportunity and sold the stock. But after the January auto sales numbers, which beat the market expectations, Maruti gained over 2 per cent on February 1 leading to frantic short-covering, as traders rushed to cover short positions initiated a few days before.

When a heavily shorted stock suddenly rises, it means a big loss for traders who have sold borrowed shares or futures. So, to avoid the loss or minimise it, traders rush to exit short positions. When many traders are in this position, there will be a scramble to buy the stock in the market, making its prices shoot up sharply. When there’s not enough stock in the market it’s called a short ‘squeeze’.

The bottomline

If you thought buying and holding a stock needs patience, short-selling it needs nerves of steel.

A weekly column that puts the fun into learning.

Published on February 04, 2019

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