What is Short Covering?

What is shorting?

Short selling (or shorting) in the market simply refers to taking a sell position in the market. Most traders feel comfortable buying first and then selling. This works when your view on the markets is bullish. However, if your view on the markets is bearish (or range-bound in case of options), traders can initiate a sell position first and then buy. This is how short-selling is done.

When to book a profit on the short position?

Now since the trader has already taken a short position, in order to square it off he/she has to take a long position. The position will be in profit when the price at the time of square off is lower than the initiation price of the short position..

How to apply stop-loss on the short position?

Stop-loss will be applied on a price higher than the initiation price of the short position.

Let us understand this with the help of an example. 

Mr. Akshay is a trader. He is bearish on Tata Motors Futures which is currently trading at ₹440 with a lot size of 2,850. He initiates a short position at this price.

According to Mr Akshay's analysis, within the next week Tata Motors futures can fall to ₹430 and that's where he wants to book his profit. Therefore, a trade with a short position is profitable when the target (buying price) is less than the initiation price of the short position (selling price).

But price can swing both ways in the market so in order to protect himself he applies a stop loss ₹445 which is higher than the price of the short. 

Mark-to-market impact:

Day 1 closing: Tata Motors futures are trading @ ₹437

The price of Tata Motors Futures falls by ₹3. He will make a mark-to-market profit of ₹8,550.This amount will get credited to his account.

Day 2 closing: Tata Motors futures are trading @ ₹434

The price of Tata Motors futures falls by ₹3 again. He will make a mark-to-market profit of ₹8,550.This amount will get credited to his account.

Day 3 closing: Tata Motors futures are trading @ ₹436

There is a rise in the price of Tata Motors Futures by ₹2. He will incur a mark-to-market  loss of ₹5,700.This amount will get debited from his account.

This mark-to-market adjustment happens daily. This position can be carried forward till expiry; it is at the discretion of the trader when he decides to exit it.

What is short covering?

Short covering refers to squaring off or taking a long position on the existing short position.

Shorting in the cash segment is only allowed on an intraday basis. So a trader has to square off his position during market hours itself.

However in the derivative segment i.e. in Futures and Options segment a short position can be carried forward. 

When the open interest in a contract decreases and the price increases, it indicates short covering. This refers to multiple short positions being squared off and is a “cautiously bullish” indicator.

Initially traders find it difficult to comprehend shorting as it is different from all the other instances in everyday life. We are used to buying something first and then selling it. The vice-versa happens on rare occasions. The profit calculation though remains the same. A trade is profitable when the buying price (long position) is less than the selling price (short position). 

Risks of shorting

• High loss potential: If a stop loss is not used and the price goes on increasing, the loss on a short position can be very high.

• Limited potential profit: The profit in a short position is potentially limited as the share or contract price can go down only to zero.