What is Short Covering?
Short covering refers to the practice of purchasing securities to cover an open short position. To close out a position, a trader purchases the same number and type of shares that he sold short.
How Does Short Covering Work?
Traders sell a stock short because they believe the stock's price will fall. But if the stock's price goes up, the trader may choose to reduce or eliminate her exposure to a short position. This process is called short covering.
For example, a trader shorts 1,000of XYZ stock at $20 per share, believing the share price will fall. Instead, the price rises to $25 per share. The trader has substantial loss exposure, so she purchases 1,000 XYZ at $25 per share to cover her short position.
Why Does Short Covering Matter?
Short covering allows traders to protect themselves against potential losses if the market moves against them. Short covering puts the trader in a market neutral position and is a common practice among hedge traders.
To learn more about short selling, click here to read Shorting Stocks: How to Find the Perfect Candidate for Profits.