What does 'short covering' mean?

What does 'short covering' mean?

When a security is sold “short,” it means that the investor did not own the security, to begin with, and the broker can require that the investor return the shares in what’s known as ‘short covering.’

Covering a short position means to acquire the securities which were sold short, and returning them to the custodian/broker that facilitated the short sale. Imagine a shopkeeper who allows a customer to lock-in a certain price for a widget, even though the shopkeeper does not have the widget in inventory.

The shopkeeper has to go out on the market and find a deal with the third party to have the order “covered” for the customer. In that scenario, the shopkeeper is hoping that the market price for the good falls in the time between sale and promised delivery, so he can purchase the widget at a lower cost and keep the difference in profit.

But if the price of the good rises from the time of sale to the time of delivery, the shopkeeper loses money. When he finally fulfilled the obligation to replace the inventory, he would have “covered” the short sale transaction.

While this analogy may be stretching it a little, it paints a picture. There is a risk that the shopkeeper would not be able to find the widgets at a good price, due to rising demand or some other influence.

If a lot of short-sellers suddenly try to cover their positions, due to indications that the security is moving up and not coming down anytime soon, they might inadvertently drive the price up even more rapidly, which is referred to as a “short squeeze.” This is more likely to happen in the wake of a compelling market rally.

The obligation to “cover” a short position can turn into a problem if the investor has not hedged somehow. While brokers rarely force a position to be covered, they do reserve that right if they feel that the likelihood of the investor covering it is dwindling.