Short Covering
Candlefocus EditorTypically, the cheaper the broker price, the more likely the trader will make a profit when the stock is returned and the greater the incentive for short covering activity. Traders can use indicators such as earnings releases and other news related to a stock, to look out for signs that may trigger a temporary drop in share price. This may then give traders an opportunity to ‘short cover’ at a lower price.
Short covering is also conducted when there’s an expectation that a stock may rebound in the near future. This is why short covering activity can often be seen following news releases relating to an individual company’s prospects. For example, a company’s earnings report could be good news for short sellers, who would then attempt to buy the stock back and sell it at a higher price shortly thereafter.
In some cases, short covering can also help to ease a so-called ‘short squeeze’. Generally, a short squeeze occurs when a security’s price rises drastically due to heavy buying pressure, which in turn forces short sellers to buy the security in order to close out their positions before prices become too high. Short covering can be seen as a means of avoiding a bigger loss if the price of the security continues to rise.
In essence, short covering offers the potential for great rewards, but also carries the risk of steep losses if the market price moves in an unexpected direction. Therefore, it pays to have an in-depth understanding of a company’s fundamentals, including financial statements and news, before making any significant decisions about a short covering strategy. Furthermore, gauging short interest can help investors better predict the chances of a short squeeze and, as a result, plan accordingly.