Short Covering to Close a Position

What is Short Covering

Short covering is the act of buying back shares in order to close out a short position.  Short covering is often a tough concept for novice traders to grasp, because it is the exact opposite of going long in the market.  The majority of retail investors understand that if they buy a stock the only way to close out the position is to sell.  With the horrendous drop in the world markets as a result of the 2008 credit crisis, many novice investors are wondering how they could have profited from such destruction.  The answer to this question is shorting the market.

Example of Short Covering

Let's assume a trader was short Citigroup at $23.50 in early October.  In order to open this position the trader would sell short 500 shares by borrowing these from their broker and selling them on open market.  This creates a net short position for the trader.  So, the only way to close out this position is to buy back or cover the position.  In the below chart Citigroup experienced a free fall down to $3.  This lead to a massive short squeeze which shot the stock up over $8 in a matter of days.

Short Covering and the Market

Many investors believe that shorting is evil.  However, shorting is a normal part of the markets and adds to its liquidity.  For example, as a stock begins to fall precipitously, many traders that are short will begin to cover their position to get out with a profit.  This short covering sends a large number of buy orders into the market which in turn creates counter move rallies.  Without short covering, the market will just continue to float lower, as buyers are not willing to step in front of a falling knife.