Short Covering and Short Squeeze: Overview & Difference

There are various techniques and strategies put into action by investors in the financial field, which are created for profiteering in the markets that seem to go with different directions.

One of the most confused but great approaches is, for example, short selling. Even though they are risky enough, with risks of short covering and squeezes.

These two events might result in enormous market movements and influence the price of stocks enormously. 

This article discusses short covering, a short squeeze, and how they differ, why it happens, how it is done, and some of the risks.

What is a short sale?

In the stock market, a short sale is referred to as borrowing shares in a stock with the anticipation of its prices lowering and selling them. 

If indeed its prices drop, the seller buys them back, returns them to the lender, and receives the difference. If their price goes up instead of lowering, then theoretically losses would be infinite.

This forms the second aspect of the concept above regarding short selling-covering and squeezing. It shows what happens to the seller of shares sold short when either they cover up the same as part of a planned strategy or get squeezed in having to repurchase.

Such processes lead to significant fluctuations in the prices of those involved, hence requiring knowledge of both aspects to any investor in order to be appropriately market-driven.

Short Covering: Definition and Procedure

Short covering is that situation in which the short selling covers the short sold stock before and makes use of the cover for the purpose of borrowing by closing the short position. 

This mostly occurs after an investor has developed a sensation that the price will shoot up upwards or at that price the feeling may develop that it does not make sense logically to hold on further through a short position.

In a short sale, the investor will borrow shares from a broker and sell them based on an expectation that the price might fall. 

If it actually falls, then that same investor can purchase the shares back at that reduced price, return them to the broker, and keep the difference as profit. 

But, in case of a price increase, then the investor would be in loss and would possibly close his position by purchasing the stock back from the market, which is termed as short covering.

Example:

• A short seller takes out a loan of 100 shares of stock XYZ, that is traded at ₹50 per share and sells them at a total sum of ₹5,000.
• If the stock falls to ₹40, the short sellers cover their 100 shares for ₹4,000 and make ₹1,000 on that trade.
• Now but if it gains value up to ₹60 then short seller will sell these 100 shares at ₹6,000, with a loss of ₹1,000. If sells its short position to prevent from this loss then it will be to cover its position from that position by buying in the market at this moment’s price.

1. Short covering occurs in any event where the short seller believes that the price of the stock will not decline as anticipated. These occur due to factors such as:
2. Positive news or earnings reports: when company fundamentals improve, or positive news improves the market sentiment.
3. Stock prices cross a certain threshold: whereby a short seller’s losses exceed and they want to reduce further losses.

Short Squeeze: Definition and Working

It is referred to as a short squeeze when any share, whether it is a stock or any other asset that witnesses many short positions, records a sudden increase in price. 

This is because the short sellers, who believe the price might fall further, have to purchase the shares they had borrowed in order to cover their position. 

Short sellers covering their position force the price up by the pressure to buy from short sellers, hence leading to a self-reinforcing cycle.

Short squeezes are much more violent than short covering since they usually involve a large number of short sellers panicking and scrambling to buy back shares. 

This situation can be made worse by other investors who start buying the stock, which can shoot the price even higher. A short squeeze can create much volatility and price appreciation in a short period.

For instance,

• If total shares of stock ABC have been sold 80 percent short, then 80 percent of the shares of that particular stock have been sold by short sellers after borrowing.
• The price of a stock goes up unexpectedly due to good news or general market feeling.
• Since the price keeps moving upward with time, the short sellers rush for the close position and this yields a hike in the price.
• As the price becomes more inflated, short sellers become scared and rush for the closing positions leading to an increasing upward momentum of stock price-this is referred to as a short squeeze.

One of the most famous short squeezes was in January 2021 with GameStop (GME). The company had a huge amount of short interest, over 100% of floating shares sold short. Then retail investors from sites like Reddit’s r/WallStreetBets buy into the stock, push it sky-high, and then the shorts are forced to cover, so the price explodes further.

What is the difference between Short Covering and Short Squeeze

Though the short covering and the short squeeze are a similar act of shorting covering, the above are different phenomena:

1. Cause

• Usually, short covering occurs as a result of the action of the short seller itself, to close their positions either in taking the profits or in an attempt to cap the losses.
• A short squeeze is usually caused by any external factor, like good news, market’s mood, or group action, which forces short sellers to cover.

2. Magnitudes

• A short cover is a regular activity but not a free action, as it requires some time to happen, and therefore is part of the plan of short selling strategy.
• A short squeeze is a highly extreme event that pushes the price to run amok at a drastic, and often rapid rate, supported by panic buying by shorters and other market players.

3Derivative on Stock Price

• short squeeze can push stock prices to moderate up-sides in case most of the short sellers are forced to close at once, though it is hardly the case that results in extreme price moves.
• When a short squeeze happens, the frenzied buying from short sellers and other traders pushes the stock prices much higher in a relatively shorter time.

4. Market Sentiment

• short covering is a change in perception or risk tolerance of the short seller, but this does not mean that market sentiment has changed.
• short squeeze often exposes the better hands of the market because the remaining investors will also catch the buyer’s bandwagon, and the stock price shoots through roof levels.

Why Do Short Squeezes Occur?

A short squeeze occurs when there is an exaggerated price increase of a highly shorted stock. There can be various reasons for it as follows:

1. Positive news or earnings surprise:

• When a company releases some good news, perhaps posting better-than-expected earnings, short sellers will have to cover their positions immediately. If the stock was shorted heavily, this might cause a short squeeze.

2. Higher Demand from Other Investors

• At other times, retail investors or institutional traders may find that the stock has massive short interest and start buying the stock. In turn, it runs up the price; the subsequent panic in short sellers as they try to cover their position raises the price even further.

3. Low Float and Limited Liquidity:

• While it is true that the stock whose floats are less (fewer shares outstanding available for trading), the more vulnerable it gets since there are fewer available to cover the shares sold short. This becomes extreme in case the short sell try to cover.

4. Short Interest Larger Than 100%

• In some instances, there are more shares being sold short than the number of available trades to share. The short sellers therefore have to buy the shares if not enough exist in a given market.

5. Social Media and Investor Communities:

• Another trigger has been the appearance of the Internet trading forums like on WallStreetBets at Reddit; all these have also escalated short squeezes. Their potency to build enormous buying pressure at the over-sold equities leads to a squeeze short

Risks of Short Selling, Short Covering, and Short Squeezes

Short selling can, however be quite fulfilling provided they are executed appropriately with immense risks associated in executing a short covering and a squeeze short

1. Risk of infinite losses:

• Unlimited losses are also one of the significant risk factors of short selling. Unlike buying stocks where an investor’s losses are generally capped at the investment cost, unlimited losses can incur to short sellers in case stock prices continue rising.

2. Margin Calls:

• oShort sellers often use (borrow) money from the brokers to borrow the shares. Once the stock price shoots up considerably, the broker issues a margin call that demands that the short seller put in more money or buy the stock to cover up the losses.

3. Short Squeeze Risk:

• Short squeezes may drive the stock’s price to shoot skyward and quickly in the upside direction leading short sellers to cover with massive losses. In bad cases, extreme short squeezes can drive stock prices miles above or below reasonable fundamentals involving fundamental facts about the underlying company.

4. Market Manipulation

• Coordinated action by investors-as in the case of the GameStop short squeeze-can lead to charges of manipulation. This creates legal risk for those involved in this type of scheme

Conclusion

Short covering and short squeeze are two of the most essential concepts that exist within the realm of short selling. A short cover is one normal part of the process for short selling when the investor covers back the shares sold in an effort to limit losses or to lock in the profits. 

But a short squeeze is an extreme situation where short sellers are forced to cover their positions because of a rapid increase in stock price and usually with high volatility.

Though short selling and short covering are part and parcel of the market, short squeeze is the less-understood phenomenon which can drastically alter the price. 

While awareness of both short coverage and short squeezes along with the factors causing them will make any investor better equipped to counter the vagaries of the stock markets and not fall into pitfalls caused. 

Now the reality is that short-selling homes is really quite risky, especially in light of short interest on stocks, so relying on it must be done extremely carefully.

Frequently Asked Questions

1. What is the difference between short and short covering?

• Short Selling means selling the borrowed stocks of a particular company with hope that its price will soon go down. If its price goes down, then he will earn by purchasing it from the market at a low price than the price at which he had sold it and return back to the lender.
• Short covering or the covering of a short position occurs when a short seller repurchases borrowed shares. These short coverings occur any time the short seller considers the price is no longer moving down or when he wants to have control of his losses in case the price of the stock increased.

In short, short selling is to borrow and sell the shares; actually, short covering is the act of buying them back in order to close a position.

2. Short covering is bullish or bearish?

• Short covering is somewhat bullish in nature since it exerts upward pressure on the stock price. The more short sellers close their position by buying back shares, the higher the demand for the stock. If lots of short sellers are covering positions at the same time, there can be a rapid rise in price.

Though a short seller could have entered his or her bearish short with unfavorable conditions in place, which could have meant that at the time, the conditions made it advisable for him to cover his or her short because the price increased and hence raises buying pressure. Such is the indication of bullish activities in the market.

3. Give an example of short covering.

Suppose a trader had borrowed 100 shares of stock XYZ at ₹3,750 per share, or $50 per share and sold them at ₹3,75,000. If the price of that stock now rises to ₹4,500 or $60, then he is still left with ₹1,000 loss per share, which amounts to ₹1,00,000. He now wants to reduce his loss. So he buys the 100 shares at ₹4,500 to close the position, where he pays ₹4,50,000. The short covering is buying back the stock so that one may return the shares and will incur a loss of ₹1,00,000 on the part of the short seller.

If the stock price had been dropped to ₹3,000 or $40, he might have covered his short selling by purchasing back the shares for a value of ₹3,00,000 and collected the profit of ₹1,00,000. Either way, the buy-back of the share’s forms part of short covering.

4. What is the difference between short covering and short unwinding?

• Short covering: It is the buying of re-purchased borrowed shares for covering a short. Primarily, it happens when the seller of the short thinks that the share price will go up or to avoid further losses.
• Short unwinding: is a general term for the covering or liquidation of short position. It could include short covering, but it is more directly related to cases where traders or investors cut up or close their short position for reasons other than reversing changes in stock price. For example, short unwinding might be due to market moves or shifts in sentiment, among others, while risk management may be one also.

The only difference between these two is that short covering is a specific short unwinding since it is the buying of shares back from the borrowed ones so that a position will be closed since the stock price has already risen.

5. What is short covering and short squeeze?

• Short covering is when the short seller buys back the shares, he sold short to close his position, usually to limit the losses when the price goes up or because he believes that the price of the stock will rise further.
• A short squeeze is more extreme when there are so many short positions in the stock and the price of that stock starts moving upward fast. As the price goes up, short sellers get forced to buy back shares in order to avoid further loss, thereby creating more pressure to buy. This will be a self-reinforcing cycle that takes the price even higher.

While short covering is a normal behavior for the short seller in his covering position, the short squeeze arises as if the external events, like panicking buying, are exaggerating the short covering process. That creates quite explosive price jumps.