Covering Your Shorts

The term “covering your shorts” sounds sort of nasty, kind of like something my 16 year old son might come up with, but shorts are just investments that go up as a market goes down.   Covering means getting out of a short investment.

An investor who thinks the market is high and will be headed lower can borrow certain number of shares from his brokerage firm and sell them (sell high).   If the market does drop, he can buy the same number of shares for less money (buy low) and replace the borrowed shares.  As usual, the investor gets to pocket the difference between buying low and selling high. The fact that someone sells before they buy sounds goofy, but buying low and selling high are still the great American investment creed regardless of the order in which you do them.

The problem comes if the market goes up when one is short.  You still have to repay the borrowed shares even if you have to pay a higher price to get them.  Since prices, theoretically, can go up forever, the risk of being wrong may be very high.  And as prices rise, traders quickly become highly motivated to cover, buying replacement shares, paying back the borrowed ones, and effectively closing out the investment.

Market tops often tend to be long gradual affairs that telegraph their arrival, sometimes over months.  I had my actively managed account clients 100% in cash prior to 9/11 because the market had been declining since May.  I had months to recognize the fact and sell off investments.

In contrast to market tops, bottoms can sometimes happen very quickly finishing with a sharp, short round of panic selling, followed immediately by a sharp round of buying.  This propensity to turn around quickly makes a “V” shaped pattern on a chart.  Holding short positions past a bottom often proves painful as gains made on the way down can be quickly erased as the market powers up out of its bottom.

These sharp surges off market bottoms are created by investors who are buy-on-the-dips types and usually quick on the trigger to buy.  The more the “dippers” step in to buy, driving the market up, the more the short holdings go backwards in value.  Traders who hold the shorts know how quickly the market can turn against them, so they don’t waste time moving to cover their shorts by buying shares.

The double whammy of dippers buying, plus short covering generating more buying is what creates these powerful upturns in the markets.  We call them short-covering rallies.

There appears to have been at least four short-covering rallies since mid June but the market as a whole is unchanged.  Our latest one was yesterday (July 24th).  It is too early to tell if this latest one day upswing will become the beginning of a significant rally, so we will just have to watch and wait for the market to tell us more.  None of the previous ones have had any follow through, so the market continues to languish.