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What is short covering? Research Team | Posted On Wednesday, March 18,2020, 05:29 PM

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What is short covering?



What is short covering?

Something unique happened on March 13th 2019. The share market kept crashing as it has after the coronavirus. On March 13th the NSE crashed more than 10% and circuit filters were imposed. Trading was halted for 45 minutes. Then something surprising happened. The Sensex got a 4,700 point lift. This was attributed to short covering. What is short covering? Let’s find out.

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See Also: Stock Market: Sell Winners or Hold on to Losers

What is short covering?

Let’s say an investor believes that a stock is going to tank. He/She sells the stock at the current price with the hope that this stock will crash and he can buy it back at a lower price. This helps the investor/trader make quick profits.

How does short covering take place?

Well, you or an investor would sell a share you don’t own. You would have to borrow this share from other market players and do the trade.  Short covering is nothing but buying back the share and covering an open position. It is commonly used in derivatives.

Example of short covering

Let’s say you are a smart equity trader and understand stock market trading in-depth. You believe that XYZ stock is over-valued and would crash. You initiate a short position (sell 100 shares) of XYZ stock at Rs 180. You believe that the stock would fall to Rs 150. You borrow 100 shares and sell at Rs 150.

Now, you have made the right call. The stock declines to 150 levels. You buy the XYZ stock from the market at Rs 150 and close the trade. You earn a profit of Rs 18,000 – Rs 15,000 which is Rs 3,000. Do note that short covering is necessary even if the stock rises and doesn’t fall. This happens if the trader wants to square off his position.

Make money when the stock market falls

Many investors/traders look to make money when the share market is going up. The smart ones look to make money when the stock market is going down. Short selling is very important as it helps correct stock prices in overvalued markets.  

Why care about short covering?

Well, it’s at the root of all big market swings. You must be familiar with the Yes Bank crisis. The Yes Bank share moved up rapidly from Rs 15 to over Rs 77 in a few trading sessions. Call this the power of short-covering.

Let’s say a heavily shorted stock like Yes Bank goes up suddenly. This will cause huge losses to investors who have borrowed shares. To avoid this loss, all traders rush to exit (get out of) short positions. This pushes up prices further as there is a wild scramble to buy the stock. This pushes up stock prices sharply. If there is no sufficient stock in the market, it’s a short squeeze. Short squeezes are triggered by positive developments.

What do you learn? Well, buying a stock requires a lot of patience. To do short-covering, well you need nerves of steel.

See Also: SIPs For A Volatile Stock Market

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