What is covering a short position

A stock rising in price can also prompt traders to cover their short positions in order to limit their losses. A short squeeze can occur when many traders have a negative outlook on a company and choose to sell short the stock. A practice known as naked short selling allows investors to sell short shares that have not actually been borrowed, which can push the number of shares sold short above the company's actual share count.

If sentiment about the company changes and too many investors attempt to simultaneously cover their short sales, that can put a "squeeze" on the number of shares available for purchase, causing the particular stock price to spike to a higher price.

The original brokerages that lent the shares can also decide to issue margin calls , meaning that all shares they loaned must be returned immediately. This further increases the number of investors trying to cover their short positions, which can cause further sharp gains in the company's share price. As just one example, many traders held a negative outlook on the brick-and-mortar video game retailer GameStop NYSE: GME because the company was losing sales to digital distribution channels.

Video game players are increasingly opting to download games instead of buying them at stores, and the company has been struggling to diversify into new sales channels. Roughly 70 million shares of GameStop stock had been sold short in early despite the company having only 50 million shares of stock outstanding. GameStop's business outlook defied expectations by improving, and this, coupled with coordinated buying among Reddit forum members, caused the stock's price to begin to significantly increase.

The investment firms with large short positions, among many other investors, clamored to cover their shorts. But the GameStop example also illustrates the risk of assuming that short covering is always possible and proves that not being able to cover a short position can result in massive losses. Since so many people are buying, this creates a temporary rise in the price of the stock. However, this price rise may not for a long period of time.

This price rise is only because people are covering positions. Consider that XYZ has 50 million shares outstanding, 10 million shares sold short, and an average daily trading volume of 1 million shares. XYZ loses ground over a number of days or weeks, encouraging even greater short selling.

One morning before they open, they announce a major client that will greatly increase quarterly income. XYZ gaps higher at the opening bell, reducing short seller profits or adding to losses. Some short sellers want to exit at a more favorable price and hold off on covering, while other short sellers exit positions aggressively. This disorderly short covering, forces XYZ to head higher in a feedback loop that continues until the short squeeze is exhausted, while short sellers waiting for a beneficial reversal incur even higher losses.

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