Short covering, also known as buying to cover, refers to the act of buying shares of stock in order to close out an existing short position. Once the purchase is made in the exact quantity of shares that were sold short, the short-selling transaction is said to be covered.

Short covering

When an investor sells a stock he or she doesn't own, it's known as selling the stock short. Essentially, short selling is a way to bet that the price of a stock will decline. The way to exit a short position is to buy back these "borrowed" shares, which is known as short covering. Once the shares are bought back, the short-sale is closed and no further obligation to the broker exists.

Traders cover short positions for several reasons. If the stock dropped and the shares can now be purchased for less than the price of the short sale, covering the short can produce a profitable end to the trade. On the other hand, since the potential for losses is technically unlimited in short-selling, traders also cover short positions if the shares are rising in price, in order to limit their loss on the trade.

An example of short covering

Let's say that you have a feeling that Company X's stock is about to drop, so you short-sell 100 shares at a price of $50, for total proceeds of $5,000. In two weeks, Company X is trading for $40 per share, so you buy 100 shares for $4,000 in order to cover the short position. In this case, the overall result of the trade would be a $1,000 profit.

Too much short covering can cause a short squeeze

Sometimes, stocks can become heavily shorted for one reason or another. As an example, in 2016 many traders had a negative outlook for the oil drilling industry. As a result, Transocean (NYSE: RIG) had short interest of 24.9% as of June 30, 2016, meaning that this percentage of all outstanding shares were sold short as of this date.

Suppose that some unexpected good news came out, and Transocean's stock shot upward. Well, I mentioned earlier that one of the main reasons traders will cover a short position is to limit their losses. So, if too many investors do this, it will create a buying frenzy and could drive the share price even higher -- known as a short squeeze.

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