When it comes to investing in the stock market, the ultimate goal is to turn a profit. The most straightforward way to do this is to buy shares at a low price and sell them when the price is high. But what if the stock's price drops below what you paid for it? That's where short selling comes in, a strategy that can potentially turn a falling stock price into a profit.
If buying low and selling high is your investment strategy, you will avoid investing in stocks that show a bearish trend. However, through a strategy called short selling, you can make profits from falling stock prices. The strategy involves borrowing a number of company shares, selling them immediately, buying them back when the prices fall, and returning them to the lender.
Short selling is a complicated and risky investment strategy that requires a deep understanding of all the aspects. One of the most important is to cover a short position, which is called short covering.
How does short covering work?
Short covering meaning in the stock market is when a short seller buys the borrowed shares that are immediately sold at a lower price to close an open short position. As short sellers borrow stocks and are not the owners, short covering is mandatory. The short sellers are required to offer the shares back to the lenders. If they fail to do so, the stock broker, who works as intermediary, invokes margin calls.
If a share experiences a high volume of short covering, it may result in a short squeeze, where short sellers are forced to buy back the stocks at a higher price because the share price is increasing rather than falling.
Monitoring short interest
Short interest is the number of shares waiting for short covering. This means that it is the number of shares that short sellers have already sold and have yet to buy again to offer them back to the lenders. It is crucial for traders to monitor short interest regularly, as a higher short interest indicates that short covering in the share market may become risky and disorderly. A higher short interest is an indication that traders and investors have become more bearish, while a lower short interest indicates that they have become bullish.
What is the difference between short interest and the short interest ratio?
Short interest means the total number of shares that short sellers are yet to buy back and offer to the original owners (lenders). It can be expressed as a percentage of the total shares outstanding against the total shares available for trading.
When short interest is expressed as a ratio, it is called the short interest ratio. The SIR calculates the total number of shares outstanding and divides it by the average daily trading volume of the stock to determine the SIR.
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Example of short covering
Here is an example of short covering in the stock market for a better understanding. Suppose you borrowed 10 shares of XYZ company and sold them immediately at Rs. 500, thinking that the share price will go lower.
Until now, you have made Rs. 5,000, but you have to return the stocks to the lender. Hence, you have a short open position. As per your analysis, the stock price falls and reaches Rs. 400. With the Rs. 5,000 you have, you buy 10 stocks of XYZ again at Rs. 400 and return the stocks to the lender, thereby making a profit of Rs. 1,000 (Rs. 5,000-Rs. 4,000).
The process where you buy back 10 shares at Rs. 400 is what short covering means in the stock market.
The GameStop short-squeeze
In 2021, a video game retailer company called GameStop saw a sudden surge in its share price because it became a meme stock (types of shares with higher social media interest). Because the shares increased suddenly, demand further increased, driving the share price even higher. This resulted in a short squeeze, where numerous hedge funds suffered significant losses as they had open short positions.
Fast forward to May 2024, GameStop shares again surged over 150%, leading to short sellers losing up to Rs. 20,000 crores.
How did short covering contribute to the GameStop short-squeeze?
The rapid increase in GameStop shares in 2021 and again in May 2024 led to frenzied buying by retail investors as they noticed a high percentage of short interest. The continued increase in prices forced big hedge funds that had open short-selling positions in GameStop to start short covering at a higher price, leading to significant losses.
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What risks are associated with short covering?
Here are some common risks associated with short covering in the stock market:
- Investors and traders can lose money if the stock price increases as they will have to execute short covering at a higher price.
- Investors and traders can witness margin calls by the broker if they fail to execute short covering before a specific period.
- Investors and traders can incur losses if they fail to find sellers when they want to execute short covering.
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The bottom line
Short selling can prove to be highly profitable if the stock price falls lower than your cost price. However, within the process, you must compulsorily execute short covering to buy back the shares and offer them to the original owners. As you may be forced to short cover at a loss, it is important to analyse the short interest and technical indicators before you open a short position and buy back the shares through short covering.
