What is short covering in stocks/trading?
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Most stock exchanges have a system where you can bet against a company. Basically this works by borrowing and selling the stock. For example if Microsoft stock is $250, and Bob shorts 100 shares of Microsoft, basically Bob scrawls on a sheet of paper “IOU 100 shares of Microsoft” and sells that piece of paper for $25,000 through the same system used to trade actual shares.
“Short covering” is making good on your IOU. If Microsoft stock goes down to $200, by short covering, Bob can buy 100 shares for $20,000 and send them to make good on his IOU. Bob makes a profit of $5000.
If Microsoft stock goes up to $300, by short covering, Bob now needs to buy 100 shares for $30,000 to make good on his IOU. In this case, he makes a $5000 loss.
Basically, Bob is betting against Microsoft — Bob wins $100 for every $1 Microsoft’s stock price goes down, and Bob loses $100 for every $1 Microsoft’s stock price goes up.
Why doesn’t Bob take the $25,000 and run? Well, the system’s designed to keep from being infected by bad IOU’s. Meaning the government and stockbrokers have a bunch of rules for customers like Bob, for example “You have to have enough money or other stocks in your account to be sure you can cover your IOU’s, plus a safety margin,” plus “You’re not allowed to withdraw money or stocks from your account if it would put you in danger of not being able to make good on your IOU’s,” plus “If a stockbroker’s customer sells a faulty IOU and the stockbroker forgets to enforce the rules on them and they withdraw all their stocks and money and disappear, the stockbroker is on the hook to make good on the faulty IOU, though they can try to sue the customer — if they can find them and if the customer isn’t broke after spending all the money on booze and hookers.”
If Microsoft stock goes up, why wouldn’t Bob just let his IOU stick around forever? Well first of all, Bob’s stockbroker charges Bob a fee for every day he owes on an active IOU. Second of all, Bob’s stockbroker can make a “margin call”, basically there’s a rule that says “If Bob’s losses mount and his IOU obligations are looking like they might soon get bigger than the money and stocks in Bob’s account, his stockbroker can seize the money and stocks in Bob’s account and use them to make good on his IOU’s.” Usually this doesn’t happen immediately, the stockbroker will typically first send Bob some urgent, strongly worded emails and phone calls telling him he *must immediately* either make good on some of his IOU’s, or deposit additional money or stocks in his account.
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