UNDERSTANDING SHORT COVERING
To Understand Short Covering, the trader must first understand Short Selling.
Short Selling, is the selling of securities (that you don't currently own) with the intention of buying them back at a later date, at a lower price. The intent is to profit from a decline in the price of the security.
Let's assume that you have been watching a particular security for some time, perhaps a somewhat obscure company involved in education, like Apollo Group. The stock of the company has risen as online education has gained more acceptance. You have watched the price go up and up and even had considered buying shares to participate in the rise, but you had not. Recently though, you began to recognize that the company was facing some serious issues. You read that graduates were not having an easy time finding jobs, that most of those enrolled had done so only because of the easy access of student loans, that the default rate on these loans was far greater than that with traditional schools, and that there had been moves in Congress to limit accessiblity to such loans for online education. All in all, you think that the business model will fail and that Apollo group is poised for a decline. You want to profit from this assessment. What do you do?
If you owned the stock you could simply sell it and avoid the loss. But, you do not own it.
You could buy put options on the stock. You could sell call options on the stock. If there were single stock futures on the stock you could sell those. But you choose another route. You choose to sell the stock short.
To sell the security short, you must first borrow it from a third party. This is your brokerage. Most often, such borrowing will be no issue, but sometimes the stock cannot be obtained easily and thus it may be difficult to borrow. By borrowing the security and selling it, you are essentially betting that the price of the security will not rise further, but instead will fall. If it does fall, you will buy it back at a lower price and thus profit from that fall in value. While holding the security, you will be responsible to the owner (from whom you borrowed the stock) for any dividends paid. Once the price of the stock falls, you may repurcase it and return it to the third party from which it was borrowed, ending the transaction.
Short selling in the futures market is a bit easier. You do not need to borrow anything. You simply have to find another party willing to take the opposite side of the deal. You want to sell, so you must find someone who wants to buy. In most markets this is easy to do, but it depends on the liquidity in that given market. Liquidity simply refers to volume, or number of participants, and measures how easy it is to get in and out of transactions at any given price. In the bond futures market for example, there is usually incredible liquidity and many buyers and sellers at most prices.
Returning to the example of selling Apollo short, let's assume that you have made the transaction to sell the stock, and are now awaiting the price fall (which you know will come) so you can buy back the stock at a lower price. You have been short for two weeks. The price has fallen and you considered purchasing the shares back, but you think you know the price will fall further. Review of the technicals reveals that price has reached an area of support, and you know that once it falls through this level, it will simply plummet bringing you a big profit. So you wait.
Unfortunately the next day brings big news. The Congressional discussions, which you felt certain to bring limits on student loans for online universities, have instead included support for such loans. You are sick. You decide you will buy back Apollo with a little profit. Again, unforunately for you, when the market opens the stock price has gapped up considerably. You have not only lost your profit, but now have a loss. You decide to wait for the price to come back down. But it does not. It goes higher, and higher still. You watch, not believing your poor luck, but refusing to buy back at such crazy prices. But apparently others do not think that the prices are crazy and the stock keeps rising, having its largest one day gain ever. By 3:30 pm you have seen the price go higher and higher and higher and though you had waited to buy back at more reasonable levels, you simply cannot take it anymore as the price is rapidly moving higher in the last hour of trading. You know you cannot sustain further losses, so you BUY...at the market. You MUST get out.
That is short covering. You have "covered" your short by repurchasing it. You did so in a hurry as price moved harshly against you. You had to buy. No matter the price. You could not handle further loss.
Short Covering can happen in any time frame. It can happen over minutes during any given day, when intra day traders choose to liquidate their short positions. It can happen over hours or days when swing traders, decide to cover. It can happen over weeks, when long term traders decide the market has fallen as low as it is likely to go. But most often, once it begins to occur, it happens quickly.
The thing to remember about short covering is that it feeds on itself. Take the example above of Apollo corporation. There were likely many traders who had gone short, just like the individual in our example. Each of them was confronted with a decision to make, once the news was released of Congressional support for student loans for the online institutions. Initially, some of those who were short, decided to buy immediately to limit their loss. These individuals, combined with new buyers who were buying on the news, caused price to gap up. Then, once price had jumped higher, other short sellers were pushed into buying back their shares. This made price go up further causing still other shorts to close positions and on and on and on, until in the end the price rise was so rapid that all remaining shorts who had any consideration of closing their position, finally did. The short covering in the early stages fueled more and more short covering as the day progressed.
Let's take another example of short selling and short covering in a situation that I have experienced many times. I trade bond futures. This is an extremely liquid market, and it is subject huge sudden moves typically when economic news is released. The 30 year bond price is quite sensitive to inflation, as you would expect. Higher inflation means that new bond purchasers will be able to get government issued bonds at higher interest rates. This would make current outstanding bonds (issued at lower rates) less valuable. Bond prices thus fluctuate when economic news is released as market participants try to discern whether the news is inflationary and whether it overides exisitng data. The Consumer Price Index, Consumer Confidence, Housing starts, GDP, and Unemployment data all have the potential to move the bond market sharply. It is in this setting that we often see evidence of short covering.
The bond market may experience several days, or even weeks, of data suggesting that inflation is on the rise. This will make bond yields rise, and bond prices fall. Traders may go with the "Trend", and sell the market, riding prices lower on short positions that are quite profitable. Inevitably, the fall will end, and often it ends with short covering. The trigger, or catalyst, for the short covering is usually a piece of economic news. Consumer Confidence has fallen to a low level unexpected. GDP was revised considerably lower than had been anticipated. Housing starts have fallen drastically. The core consume price index unexpectedly fell to new lows. Whatever the news, the time of its release is well known in advance, and day traders are usually out of the market until after the release has been noted and its implications discerned.
When the bond market trades lower, and trends for days or weeks, there are many shorts. An unexpected piece of news can then rock the market and make those shorts rethink their positions. The news release is usuallly around 8:30 am. Initially, post news, the market may move sharply, as traders try to be the first in (in the right direction) so they can profit on price movement as others pile on. A sharply lower than expected GDP or Consumer Confidence, may rocket price up a full point in seconds. This then, causes a dilema for those shorts still in the market. What do they do? Do they get out now? Or perhaps they should wait for price to retrace as cooler heads prevail and the news release is digested in context. Inevitably, if the news is severe enough, price will move higher and more shorts will close positions. Then price will move higher still, and higher still and more and more shorts cover. There may be NO new buyers. The news may not be enough to to cause new buying. But still, it may be enough to cause old shorts to cover, and the more that cover, the higher price will go, usually in a crescendo accelerating until every last short who was even considering getting out, is now out. The more shorts that buy, the more left who want to buy (because price has risen)
HOW DO WE KNOW IT IS SHORT COVERING?
The simple answer to this question is that we can never truly know for sure. But we can make some assumptions based on price movement. If new buyers were the source of the price rise, you would expect the price to continue to go up, and more and more buyers to come into the mix. At the very least, you would expect price to maintain its new level. But if short covering is the cause, that will not be the case. The price will rise, with the rise increasing in velocity as more and more shorts get out. But once the short covering is complete, there will be....NO MORE BUYERS. Once there are no more buyers, price will likely fall back again. So, in the case of short covering it is not at all unexpected for price to go up, and up, and up much more rapidly, then to pause, and fall back.
Short covering can happen in many scenarios. It often happens at the end of a trading day, in which the indices have been in a trend all day. On days whent there is a sharp trend down day for example, traders, who have been short all day, want to close out positions. This can cause a blip, up, in price at the end of the day even when news and fundamentals remain very bearish.
WHY DO WE CARE ABOUT SHORT COVERING?
One of the keys to being a good trader is understanding why the market moves the way it does. It is very important to try to understand the mentality
behind those buying and selling. If you see the Dow up 300, and know nothing else, then you must be thinking bullish thoughts.
But......if you know that the move up was only short covering, you might be less bullish.
Likewise if you were watching the market go down all day and noted at the end of the day price blip up, you might think that price had reached a low point at which buyers were now coming in. But instead, if you understood short covering you might now understand that the blip was nothing more than intraday shorts closing positions.
An Example Of Short Covering
Recently, on October 4 of 2011, we had an example of short covering which involved both short and longer term timeframes. I will review it here.
In July 2011 the equity indices broke lower. The break was harsh quickly going from 12,500 on the Dow, to 10,800, there was a bounce and then a test lower to the 10,700 area. Over the next few weeks the market traded in an almost 1000 pt. range between 10,700 and 11,600. There were a few tests on the low end.
To Understand the mentality of the traders in the market, you must understand the news of that period. Standard and Poors had downgraded U.S. debt (which would matter little to anyone with a brain, but instead had an impact on U.S. equities). The European Credit Crisis was in full bloom. The U.S. housing market had shown further weakness and consumer sentiment was falling. The Equity markets had held up relatively well, but the strain of the S&P downgrade was the pin in the balloon. There was little good news on any front. If you were trading, you had to be bearish.
When the market broke in late July, and the first week of August, this only fueled the bearish sentiment. There were many shorts in the market. But then there was a slight rebound at the 10,7000 level, and range trading thereafter. But the low end of the range was tested at least twice, and on October 4 we once again were approaching the lows.
Now if you were short, or trading with no position on that day (Oct. 4), you would have to be thinking that the U.S. equity markets were surely going to fall. The European news was worse by the day. U. S. economic news was not much better. Our market was surely to fall.
So there it was. The break came on October 4. The market gapped lower by 150 pts., then continued to trade lower, finally reaching the trading range lows, and breaking through with force. THIS WAS IT! The equities were going to break lower sharply from here and this was the beginning of that move. But then a funny thing happened. The Dow stopped going lower, and shortly thereafter bounced. "Just typical trading", had to be the thinking of those in the market that day. "The dow will go lower from here for sure", must have been the thought. After all, there was not an ounce of good news. Nonetheless, if you were short, you were likely a little concerned.
The market did retrace lower in periods H through M. The shorts were happy again. We would go lower after all. But then M period could not break below the early morning lows. There was a stall........and then some buying.
Now put yourself in this position. You are short, have been for a while, have made some money, see great profits ahead if the break occurs...............But........there is no further break. What would you do? What would you think?
You would likely be quite nervous.
When the buying came in in M period on October 4, it was only enough at first to stall the fall. But then it picked up steam. More and more buying came in. Initially, there was likely only a few shorts that decided to cover. But that caused the stall. Then a few more got nervous and got out (by buying), and the price started to rise. This made other shorts more nervous than they had been (and less profitable) and they too decided to get out. By days end there was furious buying.
This is a great example of intra day short covering. But this is also an example of short covering on a larger scale. Many different timeframes (intraday, swing, weekly, monthly) had all come to view this as a signifcant resistance level, and then viewed the trading on the October 4 as decidely NOT bearish. This caused many timeframes to cover, and price rose sharply for days. This was likely all, at least initially, short covering.
(Thanks to Terry Lieberman and WindoTrader for allowing use of the Market Profile Charts)
