Short covering is simply closing out a short position by buying back the security sold when going short. For a short covering to be successful, the security must decline in price, allowing the trader to profit from the trade.
For example, a trader shorts a stock, selling 100 shares of XYZ at $50. When XYZ drops to $35, the trader buys back those 100 shares to cover the position and close the trade, making a $1500 profit.
Short squeezes explained
A short squeeze occurs when the security’s price rises instead of falls, and traders who shorted the security are forced to exit the trade and buy back at a loss. This is usually brought about by margin calls, wherein the amount of margin a trader has is no longer enough to cover the trade because the price has moved too far against them.
The GameStop short squeeze is a famous example. The videogame retailer had been struggling in recent years, and billionaire hedge funds took advantage of this by shorting the company’s stock. Every day retail traders noticed and organized online to go long on GameStop stock, encouraging millions of people to buy in. The stock price grew from $40 to $260 within a month.
The hedge funds and investment banks that originally shorted the stock were forced to keep throwing money at their positions to avoid a margin call and many eventually did buy back their trades at huge losses. Melvin Capital lost 49% of its investments in the first three months of 2021, and London-based White Square Capital had to shut down its main fund and return capital to its investors.