Short Covering and Short Squeezing- Know in Detail

When the market is rising, as an investor/trader, you benefit from the increase in share price. But what would you do when the prices are falling? Sit and wait for the reversal. Not really - you have an option - the market gives you the option to make a profit from the fall in the stock price. How? You can achieve it through a strategy known as short selling. But before you start to use it, you must understand the complexities and risks associated with it. It takes us to short covering and short squeezing.

Meaning of Short Selling

Before we discuss short covering and squeezing, we need to understand short selling. Short selling involves borrowing shares of stock from a broker and selling them on the open market to buy them back later at a lower price. You profit if the stock price falls because you can repurchase the shares at a lower price and return them to the lender, pocketing the difference.

What is Short Covering?

Short covering is the second part of the process of short selling, which we have discussed above.

Short covering occurs when you buy back the shares borrowed to close out your short position. The process is necessary because, at some point, you need to return the borrowed shares to the broker.

How does short covering work?

Here is how short covering will work:

Stage 1: Borrowing and Selling

You borrow shares of a stock from a lender, such as a brokerage firm. You sell these borrowed shares in the market, expecting the price to fall.

Stage 2: Price Decline (Ideal Scenario)

If the stock price falls as anticipated, you can repurchase the same number of shares at a lower price.

Stage 3: Repurchase and Return (Short Covering)

You buy back the same number of shares they initially borrowed to cover your short position. You then return these repurchased shares to the lender.

Stage 4: Profit or Loss

The difference between the selling price (when you shorted) and the repurchasing price (covering) determines your profit or loss.

Examples of short covering

You borrow 1000 shares of a stock priced at Rs 100 per share (total cost: Rs 1,00,000). The stock price falls to Rs 80 per share. You repurchase 1000 shares at Rs 80 per share (total cost: Rs 80,000).

You return the borrowed shares and keep the Rs 20,000 profit (Rs 1,00,000 selling price - Rs 80,000 repurchase price).

Why Short Cover?

To adopt this strategy, you must understand why traders short cover. Here are some reasons for it:

• Profit Taking: If the stock price has fallen as anticipated, you might choose to lock in your profits by repurchasing the shares and closing your short position.
• Price Increase: If the stock price rises unexpectedly, you might cover your short positions to minimize potential losses.
• Margin Call: If you borrowed money to finance your short selling (margin trading), a broker might issue a margin call if the stock price rises significantly. This forces you to deposit additional funds or repurchase the shares to meet the minimum margin requirement.

What is short squeezing?

The idea of short selling and short covering is to profit when the stock price falls. But the price may not always fall. Short covering is to buy shares at a lower price, but what if many people start to buy? The answer takes us to a short squeeze.

A short squeeze is an event that can occur when a large number of short sellers are forced to buy back security (stock) to close out their short positions. There is a sudden surge in buying demand. And it can send the security's price skyrocketing, potentially leading to significant losses for short sellers.

How does short squeezing work?

Scary? Let us help you better understand it:

Stage 1: High Short Interest

The stage is all set when a stock has a significant short interest. It means a large number of investors are betting on the stock price to decline.

Stage 2: Price Increase (Trigger)

The stock price starts to rise unexpectedly due to various factors like positive news, increased buying pressure, or market sentiment.

Stage 3: Short Sellers Cover

Now, when the sentiments are positive, you will want to cover your position. Everyone starts doing it - the rise increases. As the price rises, short sellers begin to feel the heat. They face potential losses if they don't repurchase the borrowed shares to close their positions. This triggers short covering, where they start buying back the stock.

Stage 4: Demand Surge

The buying pressure from short covering intensifies as more short sellers rush to exit their positions. This additional buying demand pushes the stock price even higher.

Stage 5: Margin Call

If the short sellers borrowed money to finance their short positions (margin trading), brokers might issue margin calls if the stock price continues to rise significantly. It forces them to deposit additional funds or buy back the shares to meet the minimum margin requirement, further adding to the buying pressure.

Stage 6: Potential Short Squeeze

If the buying frenzy from short covering continues to outweigh selling pressure, a full-blown short squeeze can materialize. It sends the stock price soaring, inflicting heavy losses on short sellers who have not covered yet.

Example of short squeezing

Instead of talking about the hypothetical example, we take a real example to explain this to you even better.

GameStop is an American video game, consumer electronics, and gaming merchandise retailer. Institutional investors, particularly hedge funds, identified GameStop as a struggling company and heavily shorted its stock, betting that the price would continue to decline.

By January 2021, a significant percentage of GameStop's shares were sold short, creating a scenario ripe for a short squeeze. r/WallStreetBets is a subreddit where retail investors discuss stock and option trading strategies, often characterized by high-risk, high-reward trades. Members of this community noticed the high short interest in GameStop and began buying shares and options en masse.

The increased demand started to push the stock price higher. As the stock price rose, short sellers faced increasing losses. To close their short positions, they needed to buy back shares, which further drove up the price. The stock, which was trading at around $20 at the beginning of January 2021, skyrocketed to an intraday high of $483 on January 28, 2021. Hedge funds and other institutional investors who had heavily shorted GameStop faced substantial losses.

Differences between short covering and short squeezing

In the last section, we discuss the difference between the two concepts we have discussed so there is no doubt:

Before you go

Every strategy has the associated risk with it. Do not adopt a strategy because the potential returns are higher. If you plan to do short selling, you must be aware of short covering and its potential impact on your trade if short squeezing happens.

Understand the factors that influence short-covering positioning, such as market sentiment, timing, and liquidity. Once you do, you can make informed decisions and navigate the complexities of short selling more effectively.