# Understanding Short Covering: How It Works With Examples

## What Is Short Covering?

Short covering involves buying back securities to close an open short position, either at a gain or a loss. This process is known to lead to short squeezes, as seen during the GameStop stock frenzy, and it requires careful analysis of metrics like short interest and the short interest ratio. Discover how short covering impacts market movements and trader strategies in this article.

### Key Takeaways

*   Short covering occurs when traders buy back borrowed shares to close out short positions, potentially at a profit or loss.
*   Short covering can lead to a short squeeze if many traders rush to close their positions, driving the stock price higher.
*   Monitoring short interest and the short interest ratio can help predict the likelihood of a short squeeze.
*   The 2021 GameStop short squeeze is a notable example of how retail traders can impact short covering in stocks.

![Short Covering: Buying back borrowed securities in order to close out an open short position.](https://www.investopedia.com/thmb/XodR0TQux6RlwnFCTH9CKodzlBw=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/shortcovering.asp_final-950d1cb29a2b4fd9a1067a3af8ca886d.png)

*— Investopedia / Ellen Lindner*

## The Mechanics of Short Covering

Short covering is necessary in order [to close an open short position](https://www.investopedia.com/ask/answers/050715/what-difference-between-short-squeeze-and-short-covering.asp). A short position is profitable if covered at a lower price than the initial sale, but it incurs a loss if covered at a higher price. Extensive short covering in a security can lead to a [short squeeze](https://www.investopedia.com/terms/s/shortsqueeze.asp), forcing sellers to exit at rising prices due to losses and [margin calls](https://www.investopedia.com/terms/m/margincall.asp).

Short covering can also occur involuntarily when a stock with very high short interest is subjected to a “buy-in”. This term refers to the closing of a short position by a broker-dealer when the stock is extremely difficult to borrow and lenders are demanding it back. This often happens in stocks that are less liquid and have fewer shareholders.

## How to Monitor Short Interest Effectively

The higher the [short interest](https://www.investopedia.com/terms/s/shortinterest.asp) and [short interest ratio](https://www.investopedia.com/terms/s/shortinterestratio.asp) (SIR), the greater the risk that short covering may occur in a disorderly fashion. Short covering often sparks rallies following a long [bear market](https://www.investopedia.com/terms/b/bearmarket.asp) or sustained decline in a stock.  
  
Short sellers often hold positions for shorter periods than [long investors](https://www.investopedia.com/terms/l/long.asp) to avoid runaway losses in a strong uptrend. As a result, short sellers are generally quick to cover short sales on signs of a turnaround in market sentiment or a security's bad fortunes.

## Short Covering in Action: An Example

To close out a short position, traders need to buy back the shares — referred to as “short covering,” — and return them to the stock lender. Consider that XYZ has 50 million shares outstanding, 10 million shares sold short, and an [average daily trading volume](https://www.investopedia.com/terms/a/averagedailytradingvolume.asp#:~:text=Average%20daily%20trading%20volume%20%28ADTV%29%20is%20the%20average%20number%20of,find%20the%20average%20daily%20volume.) (ADTV) of 1 million shares. XYZ has a short interest of 20% and a SIR of 10, both of which are quite high (suggesting that short covering could be difficult).

As XYZ declines over weeks, traders start short positions in the stock. One morning before they open, the company announces a major upward [revision](https://www.investopedia.com/articles/stocks/06/earningsforecasts.asp) in quarterly earnings. XYZ gaps higher at the opening bell, placing traders’ positions into a significant loss. Some traders wait for better prices, while others aggressively cover their positions.

This chaotic short covering spikes XYZ's share price, creating a feedback loop until the squeeze ends. Traders who delay covering risk buying shares at ever higher prices, increasing their loss potential.  

## GameStop: A High-Profile Short Squeeze Case Study

A short squeeze occurs when investors who have shorted a stock, or borrowed shares to sell with the expectation of buying them back at a lower price, are forced to buy back those shares at a higher price to limit their losses. It leads to a sudden surge in demand for the stock, causing investors to buy back shares quickly, driving the price even higher. A [meme stock](https://www.investopedia.com/meme-stock-5206762) buying frenzy in January 2021 led to a short squeeze in brick-and-mortar video game retailer GameStop causing several hedge funds to suffer significant losses.

As a result of the shift to online gaming and declining sales, several prominent funds had built a large short position in GameStop. Retail traders noticed this high level of short interest in the stock and worked together through Reddit trading group [WallStreetBets](https://www.investopedia.com/wallstreetbets-slang-and-memes-5111311) to drive up the stock price by buying shares and options contracts. As more investors piled into GameStop, the stock price began to climb rapidly, causing some of the hedge funds with short positions to suffer steep losses. In an attempt to reduce risk, some of these funds began buying back shares at a much higher price than they had initially sold them for to protect against a further rising prices. 

> **Fast Fact**
>
> Institutional investors lost roughly $19 billion short-selling GameStop in January 2021, according to data cited by Business Insider.

The squeeze worsened as hedge funds shorted more shares than were available, making it difficult to cover all positions. This added immense pressure to buy back shares at any available price, further pushing up the stock price. The frenzied buying by retailer traders resulted in short covering by [institutional investors](https://www.investopedia.com/terms/i/institutionalinvestor.asp), creating a feedback loop that kept pushing GameStop shares higher. Ultimately, the squeeze caused some hedge funds to lose billions of dollars, and the stock price to rise from around $20 per share to over $400 in just a few weeks.   

## How Does Short Covering Work?

Short covering works by closing out a short position that an investor has made by buying back shares that were initially borrowed and sold. When an investor shorts a stock, they borrow shares from a stock lender and sell them on the market, with the expectation of buying them back at a lower price in the future. If the stock goes down, the investor's short position generates a profit, but if it goes up, it results in a loss. Increased short covering has the potential to trigger a short squeeze and cause significant losses.

## What’s the Difference Between Short Interest and the Short Interest Ratio?

Short interest refers to the total number of shares that have been sold short in a specific security that has not been covered or closed out. Investors use the metric as a measure of bearish sentiment. Short interest can be expressed as a percentage of the total shares outstanding or as a ratio of the total shares that a company has available for trading. By comparison, the SIR takes the number of shares held short in a stock and divides the figure by the stock's average daily trading volume. Investors use this metric to determine how many days it would take to cover all short positions in a stock.

## How Did Short Covering Contribute to the GameStop Short Squeeze?

Retail traders noticed a high level of short interest in GameStop and worked together through Reddit trading group WallStreetBets to coordinate frenzied buying in the company’s shares and options. The increased sudden buying pressure forced several hedge funds who had bet against the videogame retailer to promptly cover their large short positions at a significant loss, creating a short squeeze in the stock. The short squeeze was exacerbated by several funds shorting more shares than the available float of shares in the market, making it difficult to cover all their short positions.

## What Risks are Associated with Short Covering?

Investors who cover a short position at a higher price than they initially shorted the stock for will incur a loss. The act of short covering can trigger further buying, creating a short squeeze in the stock, increasing the potential for significant losses as traders scramble to buy back shares at progressively higher prices. Before initiating a short position, investors should monitor a stock’s short interest and SIR to determine the likelihood of a short squeeze occurring.

## The Bottom Line 

Short covering involves buying back borrowed shares to close a short position, typically leading to either a profit or loss. Short sellers, aiming to avoid losses from potential short squeezes, often cover their positions more quickly than long position investors do, particularly if there is a shift in market sentiment. High short interest and short interest ratios increase the likelihood of disorderly short covering, potentially culminating in a short squeeze.

The GameStop short squeeze of early 2021 exemplifies how a meme stock buying frenzy can lead to substantial losses for institutional investors heavily shorting the stock.  

> **Article Sources**
>
> 1.  FINRA. "[Short Interest - What it is, What it is Not.](https://www.finra.org/investors/insights/short-interest)"
>     
> 2.  The New York Times. "[Melvin Capital, Hedge Fund Torpedoed by the GameStop Frenzy, is Shutting Down.](https://www.nytimes.com/2022/05/18/business/melvin-capital-gamestop-short.html)"
>     
> 3.  Business Insider. "[Short-Sellers are Nursing Estimated Losses of $19 Billion in 2021 After Betting on GameStop's Share Price to Fall.](https://markets.businessinsider.com/news/stocks/short-sellers-sitting-on-19-billion-of-losses-on-gamestop-data-shows-2021-1-1030020684)"
>     
> 4.  Reuters. "[Explainer: How Were More Than 100% of GameStop's Shares Shorted?](https://www.reuters.com/article/us-retail-trading-shortselling-explainer-idUSKBN2AI2DD)"