Occasionally you might hear about a stock that will undergo serious covering in a short amount of time while there are few to no sellers to supply the shares. This is referred to as a short squeeze. This is one of the few events where stock covering really becomes noticeable and significant since it happens in a narrow period of time and affects the share price. It is also one of the few times that you can say with more certainty that what you see is short covering versus actual buying of stock.
Shorting a Stock
To understand stock covering, you need to be aware of what it means to sell short. When a stock trader sells short, he borrows shares from a trader who is long a stock, and sells to another trader who wants to own the shares. When the price declines, the short seller buys back the stock at the lower price and returns it to the trader who was long. This is "covering" a short position.
Inner Workings of Buying and Covering
Actual stock buying involves a trader putting in an order to buy stock either at the current asking price, the price at which a seller is willing to part with shares, or at some price lower than the asking price. Buying at the ask is immediate while buying on the bid involves waiting for a trader to sell onto that bid. The actual stock buyer would sell and close his position by waiting on the ask or immediately selling on the bid. A short seller initiates his position by either selling on the ask or on the bid, but on borrowed shares. When the short seller wants to close the position, he either buys shares on the ask immediately or waits to buy on the bid.
There is almost no way to tell if a trade is normal buying or stock covering. Behind the scenes there are plenty of differences, but for the outside observer there is no way to know what is occurring. A short seller is no different from an owner of the stock selling her shares. When that short seller covers, she is no different from a buyer. When a potential short squeeze is under way, you can guess with more certainty that the trades are short covering, but there is no way to confirm this.
Effects of Covering
When a short seller opens a position, there are twice as many shares as there were initially. The person borrowed from has guaranteed shares, as does the person to whom the short seller sells the shares. A bookkeeping entry denotes the owed shares, but for a time, while the position is open, there are two different people with the same shares. Both have a right to sell those shares. When a stock is covered, the balance is restored and that doubling of the shares disappears. This can have the effect of magnifying the effect of price movements. Rarely are stocks so bereft of liquidity that this is perceptible. However, during a short squeeze, you may see the share price increase at an accelerated rate, as the artificial liquidity created by short selling contracts. The trader covering takes shares from a seller and returns them to a person who already owned those shares. In effect, those shares bought in the covering vanish, and the bookkeeping entry is wiped.
Nihar Patel covers finance and investing for several online publications, including Seeking Alpha. He also runs his own investment analysis website. Patel holds a J.D. from UC Hastings College of Law, as well as a bachelor's degree in political science and history from UC Davis.