What is Short Covering in Stock Market & How to Identify Rally?

 

In the stock market, apart from economy and industry-related news, various trading-related factors affect the movement of the index. GDP data, Industrial production growth, purchasing manager index, employment data, inflation and the central bank’s monetary policy are the leading factors that encourage or discourage the stock market to move further.

While on the other hand, any distress or negative growth is also responsible for the downfall of the main indices like Nifty and Sensex. These are the fundamental factors like corporate actions affects the stock market moves and have long-term effects.

While on the other hand, a few technical factors also influence the stock market direction. Though, these technical factors have short-term effects but are one of the very essential parts of technical analysis and intraday trading.

Short covering is one of them, maybe you have heard about this term, so let’s find out what is short covering, how it works, what happens after short covering, what happens after short covering rally and how to identify the short covering rally with examples.

What is Short Covering in Share Market?

Short covering is the action that comes because of the obligation to cover the position created by short-selling. Usually in the intraday and F&O segments or derivatives market, traders do the short-selling of the stock they don’t have. And because of being unable to make the delivery of shares to buyers, they have to cover their short selling and close the position.

Short covering means in the stock market is closing the open option that has been created to short certain shares of the company. In stocks, short covering involves the purchasing of stock that has been short-sold and at the same time returning the same stocks to whom from where it has been borrowed. Short-covering is the reverse action of short-selling.

What is Short Covering in Stocks?

Short selling and short-covering in the stock market can happen either in individual stocks or indices that are traded through the underlying index in the derivatives market. When the short positions created in the future of the underlying index and position are covered in the same future index, then it is known as short-covering in the indices.

While on the other hand, short covering in stocks means when the same short position is created and covered in any individual stock. In the cash market if you created a short position in a stock for intraday, then you have to close or cover your position on the same day before the end of the trading hours, otherwise, the exchange will automatically square off your position and whatever loss or profit will be transferred into your account.

How Does Short Covering Work?

Short covering simply works in speculation that the price of a particular stock is going to fall for a few days and traders “Make hay while the sun shines”. Yes means to say, traders take advantage of such falls and try to make profits by short-selling in the stocks. As in such a falling market, highly volatile stocks fall at more speed compared to others.

As traders take advantage of the falling market by creating short positions in such stocks that are likely to fall. And when they cover their position in that stock, it is short covering. In short-covering it is not necessary for traders to earn a profit, if the stock bounces back and rose instead of falling as per the expectations, they might also incur losses too.

What Happens After Short Covering?

When traders start covering their short positions they don’t see whether it is profit or loss, they have to square off their positions otherwise exchange will do this at the end of the day (for intraday trading) or on the last date of F&O contract expiration.

In this short-covering process, traders book the profit of whatever they are earning, and if they are incurring a loss, they try their best to minimize the losses. And when there is a huge number of buying starts in the market, the entire market moves up making the market and short covering stocks in the green zone, the resulting market ends higher.