For the sake of completeness, perhaps I can add my own two penn'orth on short covering. As previously explained, a short position involves selling shares you don't own with a view to making a profit on a fall in price. Eventually you have to give them back to the original owner, which means buying them in the market at the price then prevailing. Obviously the hope is that you buy them back for less than the price at which you originally sold.
When you buy a share, the maximum at risk is the price you paid. If the share goes to zero, then you have lost your initial stake, but no more. With a short position, risks are unlimited. So you may sell at a 100 in the expectation that the price will fall to 80, giving you a profit of 20. If the price starts to rise, there is no limit as to how far it can go. Share prices can double quickly (particularly after a prolonged fall). A takeover bid may come in which raises the price. So you may sell for 100, which drops 100 into your account - some of which will be needed to buy back ("cover") later, but if the price rises to 1000, then you have a loss of 900 - hence the derivation of the expression "don't get caught short" - nothing to do with toilets!
After a prolonged fall, those holding shorts may feel that it is time to take their profit, so they "cover their shorts" by buying in the shares they have shorted so that they can be returned to their original owner. This buying can push up prices, and those who remain short see their profits decline, so they also decide to cover, increasing the buying volume, and accelerating the price rise. A rise in prices may be read by those not already in the market that a recovery is in place and these investors/traders may also start to buy, adding to the wave of buying from the covering shorts. This goes some way to explaing why initial recoveries can be so dramatic. One minute you have investors selling shares they hold, and there are also traders short selling, and no one buying. Then traders start to cover their shorts, genuine buyers also come in, and everyone who wants to sell has already sold. Short covering + genuine buyers + no sellers = a price spike up.
A sudden rally in prices due to short covering can be frantic, and is known as a "short squeeze". Market Makers may mark up prices if they know that there are a large number of short holders of the stock to shake them out. The big question when these rallies take place is whether it is just due to short covering - in which case once the shorts have closed their position the buying will dry up and the liklihood is that the share will revert to the original trend - or has the rally been caused by new buyers, in which case the buying may continue leading to a sustained rise in price.
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regards,
Roger(M)
http://www.wehanghere.com
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