How Do I Tell the Difference Between Real Stock Buying and Stock Short Covering?
When investing in the stock market, a speculator can place an order on a particular stock whether he believes the price of the stock will go up or down. If he believes the outlook for the stock is trending higher, he will buy the stock and hold it until he believes it has maximized in value, at which time he will sell. If he believes the stock will decrease in value, he can short the stock and cover it when he believes it has bottomed out. The difference between real stock buying and short stock covering depends on which way he believes the stock will move.
The process of buying a stock and holding it within a portfolio is called "going long." The investor believes the value of the stock will increase, so he buys at a price today and hopes to sell at a higher price in the future. His profit is the difference between the selling and buying prices, minus any fees charged by his brokerage.
If an investor believes the price of a stock will drop, she can short the stock. To perform this maneuver, she borrows the shares from her brokerage firm and immediately sells the stock. At a later date, she covers the short by buying the stock back, hopefully at a lower price, returns the shares she borrowed to the brokerage and pockets the difference, minus fees. Shorting stock is risky, because if the price begins to rise, she must cover the short quickly, which may be costly if no sellers are willing to sell their shares.
If the price of the investor's shorted stock begins to rise, his brokerage may ask him to put more money in the account to protect the value of the brokerage's loan of the shorted stock. This is known as a margin call. Most brokerages require a short seller to hold at least 150 percent of the value of the shorted stock in his brokerage account to protect against margin calls. This amounts to the 100 percent acquired from the short sale of the stock, plus an additional 50 percent out of the investor's pocket. The investor cannot use any of those funds while the short is in play.
Naked Short Selling
Occasionally an investor will attempt to short a stock that's inaccessible to her or unavailable due to an error. While the buyer won't have to pay until the investor can supply the stock to sell, the transaction may still affect the stock price. While naked short selling isn't technically against the law, it does have the potential to artificially cause a stock to appear higher or lower in value than it otherwise would under normal market conditions.
Chris Baylor has been writing about various topics, focusing primarily on woodworking, since 2006. You can see his work in publications such as "Consumer's Digest," where he wrote the 2009 Best Buys for Power Tools and the 2013 Best Buys for Pressure Washers.