Short positions and short trading in the Indian stock markets are legal ways for investors to make money during a stock’s weak conditions. Short-sellers seek to take advantage of declining stock prices. But sometimes, the situation changes rapidly, and market direction shifts contrary to their expectations. In such a situation, the shares that short sellers sold in the first place become more in demand, leading them to cover their short-run by repurchasing them faster.
In simple terms, short-covering refers to the purchase of securities to cover an open short position. It shows the actual purchase of securities or assets by a short seller to replace those borrowed during a short sale.
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To close the position, traders purchase the same number and type of security they sold in their short position.
Traders sell a stock short when they believe the stock’s price is set to fall. However, if the stock’s price goes up, the trader may reduce or eliminate his exposure to a short position. This is called short covering.
Let us understand the working process of the short-covering practice in the stock market.
Price increment in short positioning
Prices are expected to fall during short positioning. Traders register a profit if a stock’s price falls. But if the price rises, they can encounter severe losses. Therefore, they may rush to exit the short position by buying back the stock. But as the demand goes up, the stock’s price rises too. This results in a short-covering rally.
Short covering is how short position traders in the market settle their trade; the buy transaction closes out their initial sell order. Short covering is a unique situation where people start buying to settle their positions.
Since many people buy, this increases the stock price in the short term. However, this price increase does not last long; it increases only due to demand-supply mismatch in the short time.
Example of short covering
For example, a trader shorts 1,000 shares of Asian Paints at Rs. 330 per share, assuming the share price will drop. Instead, the price rises to Rs. 350 per share. To cover their short position, the trader purchases 1,000 shares of Asian Paints at Rs. 350 per unit. In this situation, s/he makes a loss of Rs. 20,000 i.e. (350 – 330) x 1,000 shares.
However, if the price of Asian Paints had dropped to Rs. 300, they would have covered the short at that price and made a profit of Rs. 30,000 i.e. (330 – 300) X 1,000 shares.
Thus, short-covering helps traders protect themselves against potential losses if the market moves against them.
Pros and cons
There is always the opportunity to make large profits in trading. Traders can make a profit by participating in short trading without the need for short covering. Short sellers make a profit by selling short and repurchasing shares at reduced prices. This also increases supply, so there is the potential to push a stock down.
However, buying shares for short covering has a different impact on the market than trading through regular buy orders. If many people buy simultaneously, there is a greater demand for a stock and can lead to profit costs (reduction).
Or worse, it can potentially trigger a short squeeze. When several short sellers close simultaneously, a short contraction occurs. As everyone tries to buy to close their positions, the demand rises, and so does the stock price.
The short covering can occur on its own when a stock with high short interest is forced to a “buy-in”. The term refers to a situation when the broker temporarily closes the position. In this case, it is difficult to borrow the securities, and the creditors demand payment. This happens with less liquid shares that have even fewer shareholders.
In a nutshell, to indulge in the short trade and related practices successfully, it is crucial to understand the way the stock market works and seek expert guidance in case of doubts to avoid significant losses in volatile situations.
