Short covering occurs when an investor who had sold a stock short decides to unwind the position. A short sale can be executed directly, or by purchasing put options, which mimic the payouts of a short sale. If short covering becomes extreme, short covering in mass quantities is known as a short squeeze.
In a short sale, an investor bets that a stock will decline in price. To sell short, the investor borrows shares from a broker and then sells it on the open market, hoping to buy it back at a lower price to return to the owner. Buying the stock back is called short covering, or covering a short position.
A short squeeze is special situation that can occur after a short sale. A short squeeze generally occurs when positive news or developments break regarding a company that has a large percentage of its shares sold short. Because investors expect the stock to go up following good news, there is a rush of short sellers trying to cover their short positions to reduce their losses. The rush of short sellers trying to buy back shares pushes the price higher up, creating a squeeze of buyers, causing more losses for those who still have open short positions. A short squeeze can be a short-term, one-day effect, or a longer-term process.
A short squeeze can be relatively common because after a short sale, an investor has unlimited downside, since a stock can theoretically appreciate infinitely. Following a short sale, investors tend to be quick to close out their position by short covering.
Profiting From Short Squeezes
Certain investors will take the other side of a heavily shorted stock in hopes that there will be excessive short covering that leads to a short squeeze. A high short interest can be a sign that all the investors who want to execute a short sale have already done so, and the only move left for them is short covering. A short squeeze can be highly profitable if an investor is on the other side of the trade.