What Happens After Short Covering?

Short covering is part of the larger short selling strategy and is a way to make money on betting that a price of a stock will decline, but what happens after short covering? Here we explain short covering, how to identify short covering indicators, and what strategies investors use to mitigate losses associated with short selling.  

What Is Short Covering? 

Short covering, also called “buying to cover,” is part of the short selling strategy.

Short selling is a way to bet that price of a stock will decline. The way traders can exit a short position is to buy back borrowed shares in order to return them to the lender, which is known as short covering. Therefore, short covering simply refers to the process of buying back securities in order to close out an open short position. The goal of short covering is to sell a security and buy it back at a lower price. 

The overall short selling cycle looks a little like this:

1. Opportunity: A trader sees an indication that the price of a given stock will soon decline.  
2. Opens Short Position: The trader then borrows shares of the stock at the current price.
3. Selling the Stocks: The trader sells the borrowed shares, which is known as selling short. 
4. Waiting Period: The trader now must wait and hope that the stock price of the shares continues to fall. 
5. Closing A Short Position: Once the stock has fallen, the trader then uses the money they gained from selling the borrowed shares to buy back the same shares at a lower price per share. This is known as closing a short position. 
6. Profits: If all works accordingly, the trader should be left with a profit from the short selling cycle. 

For example, if a trader believes the price of a certain stock might be heading lower, they could sell this stock and then buy it back later at a lower price per share.

So, if the trader sells 100 shares at $20 and then waits to buy back these 100 shares until the price of the stock is $15 per share, then the trader would gain a $500 profit by following the short covering strategy. 

Short Covering Indicators 

While there aren’t any dead giveaways when it comes to identifying short covering, there are certain indicators you can look out for to help you better identify a short covering rally.

Some key short covering indicators include: 

• A sudden spike in the stock price, especially one without a clear catalyst. 
• When the price is rising, with a fall in open interest, short positions are often being covered. 

It’s also important to note that when there is a great deal of short covering occurring in stock or security, it may result in a short squeeze. In a short squeeze, short sellers are forced to liquidate their positions at higher prices as their brokers invoke margin calls. This will often result in a loss.   

What Happens After Short Covering? 

So, what happens after short covering? Well, if the trader made the correct decision and was able to buy back the stock at a lower price, then they buy it back, and the trade is closed, and the trader makes a profit.

If the trader doesn’t judge the market properly, this may result in a loss.  

How To Identify Short Covering Rally?

In a short covering rally, the charts will show fast and hard movement off of the lows and will not go sideways but will actually show a downward movement in the price.

If a trader is buying new stock from purchasing stock after the lows, it does not affect the stock charts in the same manner.  

How Does Short Covering Affect Stock Price?

Overall, short covering can have a significant effect on stock price. When a stock is heavily shorted, and more investors are buying shares, the stock price is pushed up. As a result of the increase in stock price, short sellers start buying to cover their position in an effort to minimize their losses as the price continues to rise.

As short sellers continue to buy the stock, this can create a short squeeze and cause the stock price to push higher. 

Short Covering Example

A recent example of short covering that occurred on a large scale was that of GameStop stock. In early 2021, around 70 million shares of GameStop were sold short despite the fact that the company had only 50 million shares of stock outstanding. 

Thanks to a strong community of Reddit forum members that coordinated their buying strategy, GameStop stock raised significantly.

In turn, this caused investment firms with large short positions in GameStop to scramble to cover their shorts. With a huge selloff in shares to cover shorts, GameStop stock increased by nearly 1,700% in less than a month. This enabled investors who owned GameStop stock to enjoy incredible gains. 

This GameStop example illustrates the risk associated with assuming that short covering is always possible. While short covering strategies can result in massive gains, they can also result in massive losses. Therefore, it is essential to know what you are getting into before investing your money in a short covering strategy. 

How To Cover Short Position With Options 

One way investors work to limit the risk of short selling is by working with options. The biggest risk associated with a short position is that the stock price may surge. Options trading gives short sellers a way to hedge their short positions and limit the damage if prices of a stock suddenly spike. Essentially, a trader can sell a stock short and buy a call option simultaneously with the goal of mitigating the loss that could incur if the stock suddenly rises.

For example, imagine a trader shorts 100 shares of a stock that is trading at $56. If this stock suddenly rises to a price of $66 or higher, this would lead to a substantial loss on the trader’s short position. However, if the trader bought one call option contract of the same stock, which is also for 100 shares, at the same time with a strike price of $55 that expires in one month, the trader could salvage some value. 

Essentially, if the $55 call is trading at $4 per share, it would cost the trader $400 to exercise the call option. If the price falls to $50 over the next month, the trader will gain $600 on the short position minus the $400 cost of the call option for a net gain of $200. 

([$56-$50] x100) – $400 = $200 (short position) 

The real benefit of hedging your short position is efficient if the stock rises instead of falls. If the stock price rises to $66, the trader will incur a loss of $1,000. However, the trader’s loss on the short position would be offset by the gain from the long call position as the call option would trade at a minimum of $11, resulting in a profit of $700. 

([$56-$66] x100)= -$1,000 (short position) 

([$11-$4] x100) = $700 (long call option) 

-$1000 + $700= -$300 

So, by utilizing a short position and a call option, a trader would incur only a $300 loss rather than a $1,000 loss. 

Frequently Asked Questions

What is Short Covering? 

Short covering refers to the process of buying back securities in order to close out an open short position.

What is the difference between Short Covering vs. Short Squeeze?

In short squeezing, the stock price rises significantly, leading to a situation where traders rush to close their short positions due to the increasing stock price. 

In short covering, traders hold their short position, and it is the buy transaction that closes out their initial sell transaction.  

Can you sell a stock short and buy a call option simultaneously? 

Yes, selling a stock short and buying a call option is possible and can help mitigate the risk associated with short selling. 

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.