What is short covering in stocks/trading?


What is short covering in stocks/trading?

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When you sell a stock short, you borrow the stock you sell. You’re in effect betting the stock price will fall and you will be able to buy the stock at the lower price in order to repay the shares you borrowed. When you buy the shares to payback what you borrowed, you’re covering your short sale. If the price of the stock falls, you make a profit, if the share price goes up, you have a loss.

The basic idea is this –

1) You predict a certain stock is going to lose value very soon.

2) You “buy” the stock from someone with the promise of giving them back the same number of shares in the future.

3) You then sell the stock you bought putting $ into your bank account and you can make other trades/deals.

4) After the time passes you need to go and rebuy the shares you sold and give them back to the person you bought them from. If the stock has indeed lost value it costs you less $ to rebuy them than you earned when you sold them originally, good deal for you. If you were wrong and the stock gained in value, you’re going to lose money because the shares are now more expensive to rebuy than you original earned.

5) “Short covering” is the moment of reckoning when you need to rebuy the shares you sold and give them back the owner.

Short covering is when a trader who has sold a security “short” buys it back to close out the position. A short position is when a trader sells a security they do not own, hoping to buy the same security back at a lower price so they can have a profit.

Short selling is betting the stock will go down. Here’s how it works.

I have a feeling that Acme Biomedical will drop in value soon. So, I call up a friend that I know invests in the company, Wile E. Coyote.

I call up Mr. Coyote and arrange to borrow 1000 shares of stock for 30 days. The agreement is that in 30 days, he will have his stock back.

Right now, Acme is selling for $10 a share. That makes this stock worth $10,000. I sell it. All of it. I now have $10,000 in cash.

Over the course of the next few weeks, Acme stock is falling, like I knew it would. On day 29, Acme stock is selling for $5 a share. So, I purchase 1000 shares. This costs me $5,000.

I return the 1000 shares of Acme stock to Mr. Coyote. He has his shares back, and I have $5,000 in my pocket.

My purchase of the stock is covering the short, because I have to return it to Mr. Coyote. Of course, it’s a bigger issue if the stock price goes *up*, because I still have to cover the stock. If the price went up to $15 a share, then I’d have to buy the stock for $15,000 so that I can return it, and the venture cost me $5,000.

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.