When is the short covering in stocks executed?
Generally, short-covering is executed amid the speculation that the stock price would rise. Thus, for realization of profits, the short position needs to be covered by purchasing securities at prices lower than the original selling price.
Example illustrating Short Covering:
In case a trader short sells 10 shares of company 'X' at Rs. 50 per share in the speculation that is likely to under perform. However, contrary to his anticipation, the stock performs better and witnesses an upside to reach Rs.75 per share. Thus, in an attempt to limit his losses, the trader covers his short position by purchasing the same number of shares at Rs.75 per share. Profit in the short-sell position is however realized when the position is covered at a price less than the selling price at which the stocks were sold short.
Short covering rally in the context of short covering
Short covering rally is a rally in cover position propelled by an increase in the buy orders when large set of investors need to close out their sell positions in a specific stock.
Forced covering happens in the event when the investor from whom the stocks are borrowed for short-sell decides to sell the stocks. This decision of the original owner of stocks requires the short seller to cover his short position i.e. buy the same stock in same number on a forced basis. There is yet another instance which requires the short seller to cover his short position i.e. in case of increasing losses when the stock price trades at a higher price.
Impact of extended short covering
In general, surge in short covering by traders on any particular day is known to push benchmark indexes, including Sensex and Nifty, upwards.