Short Covering

What It Is:

Short covering refers to the practice of purchasing securities to cover an open short position. To close out a position, a trader purchases the same number and type of shares that he sold short.

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 shares 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 shares 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.