What It Is:
How It Works/Example:
Traders sell a stock short because they believe the stock's price will fall. But if the stock's price goes up, the trader may choose to reduce or eliminate her exposure to a short position. This process is called short covering.
For example, a trader shorts 1,000 of XYZ stock at $20 per share, believing the share price will fall. Instead, the price rises to $25 per share. The trader has substantial loss exposure, so she purchases 1,000 XYZ at $25 per share to cover her short position.
Why It Matters:
Short covering allows traders to protect themselves against potential losses if the market moves against them. Short covering puts the trader in a market neutral position and is a common practice among hedge traders.
To learn more about short selling, click here to read Shorting Stocks: How to Find the Perfect Candidate for Profits.