What is Short Covering?

by Investing School on March 21, 2011

The term “Short Covering”, which is also known as a “buyback” or a “buy to cover” makes reference to a purchase of securities that is made to close an open short position. This goal is accomplished by acquiring the same number and type of the securities that were sold short to begin with. In most cases, traders will make purchases to cover their shorts whenever there is conjecture that the securities’ values will increase. In order for the investor to reap a profit, the short seller needs to cover the short positions by buying the securities below their initial sale price.

As an example, consider a hypothetical situation in which an investor has sold short 100 shares of stock in struggling Company XYZ at the price of $5 per share. He or she makes this decision because of the hypothesis that Company XYZ will continue to see a serious decline in business over the immediate future. However, despite this supposition about the company’s future prospects, it turns out that Company XYZ sees a reversal of its fortunes and improves substantially.

Unfortunately for the investor, Company XYZ’s stock price increases to $10 per share. In an effort to curb his losses, the investor makes a decision to cover his short position and buy back the 100 shares that he or she recently sold short, even though this means purchasing those shares at the increased price of $10 per share.

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