In most cases, trying to sell something you don't own is called fraud. In the stock market, it is legal and known as short selling. Short selling allows you to profit from a decline in the price of a particular stock. Once you sell a stock short, however, you are obliged to buy it back at some point. This buyback is known as short covering.
A short sale occurs when an investor borrows a stock that is held in the account of another investor and sells it at prevailing prices. By purchasing the stock later, at a lower price, the short seller can replace the shares for less than the original proceeds and profit from a decline in stock prices. Buying the stock back to replace the borrowed shares is known as closing out, or covering a short.
Suppose you believe that the price for a share of Microsoft stock has risen too far too fast and think that a pullback is imminent. To profit from the decline in Microsoft stock, you can enter a short sale order for 1,000 shares of Microsoft via your broker. To execute this order, your broker will find a customer who is holding Microsoft in her account and sell these shares at the prevailing price of, say, $20 per share. The total proceeds are $20,000. If the price of Microsoft stock declines to $18 in a month, you can ask your broker to cover this position. The broker would then use $18,000 of the original sales proceeds to buy 1,000 shares, place them in the original account and, after deducting commissions, give you the $2,000. A handsome profit for a month. If, however, you were wrong in your initial assessment and Microsoft shares advance to $22, you must pay $2,000 which will be added to the original $20,000 to buy back 1,000 shares. This $2,000 plus any commissions will be your loss.
Should the original owner decide to sell the shares you borrowed from that account, you must immediately cover your short and deliver the shares. This is a forced cover. Another reason you may have to cover your short position is mounting losses. When you short a stock, you will not only lose money as a result of advancing prices, but are also responsible for dividend payments. When for instance, Microsoft makes a dividend payment that would have resulted in $500 net cash inflow to the account holding 10,000 Microsoft stock, the short seller must supply in cash $500 to the account from which the shares have been borrowed. This is because the original buyer is entitled to this payment and cannot be denied this right.
Short Covering Rally
When a large number of investors must cover their shorts in a particular stock, they can fuel a rally with their influx of buy orders. This is known as a short covering rally. Especially when the stock price advances quickly, some of the original owners may wish to sell to pocket the gains, which results in forced covering. Furthermore, many short sellers will scramble to buy the stock to cover their shorts and put an end to the mounting losses. Under such circumstances, a heavily shorted stock can rapidly advance.
Hunkar Ozyasar is the former high-yield bond strategist for Deutsche Bank. He has been quoted in publications including "Financial Times" and the "Wall Street Journal." His book, "When Time Management Fails," is published in 12 countries while Ozyasar’s finance articles are featured on Nikkei, Japan’s premier financial news service. He holds a Master of Business Administration from Kellogg Graduate School.