What is meant by a short covering rally ?

Question

how long can such a rally last ?

Answer 1

Ever since the Nasdaq bottomed on April 4th, 2001, the financial news media has repeated that phrase ad nauseam. Cliches of this sort appear whenever the pundits are confronted with a situation that does not neatly fit into their expectations. Unfortunately, these statements make their way into the public consciousness with alarming regularity.

How do these generalizations stand up to rigorous evaluation? Are they sound from an economic standpoint?

The Sound Bite: "Is this a real rally or just short covering?"

Viewers of CNBC and CNNfn have heard numerous commentators making comments along these lines: "This last leg up has been nothing more than a Short Covering Rally." This explanation began making the rounds almost as soon as the rally started in early April.

There's little doubt that professional traders and hedge funds have been successfully shorting stocks for the past several quarters. The past few rallies gathered momentum, or so we are led to believe, when the "shorts" were forced to cover after the initial bounce off the bottom; As their positions moved against them, they were subject to margin pressures, leading to a second round of short covering. Soon after, borrowed stock was "called away;" i.e. demanded to be returned by the owner/lender of the original shares. Short sellers were then forced to repurchase shares in the open market at higher prices, in order to return them, leading to yet another round of buying.

Assuming the factual scenario above is accurate, does it hold up to scrutiny? Is a "Short-Covering Rally' quantitatively different from traditional long buying?

Short Covering in the Stock Market

I've come to the exact opposite conclusion: the "Short Covering" phenomena is not inferior to traditional buying and selling. Short covering rallies have qualities which make them superior to conventional buying. These differences have an impact on the nature and duration of subsequent market movements.

Price movements in any market are a function of Supply and Demand. To the seller of non unique goods, such as shares of stock, the buyer's motivation is largely irrelevant. As long as the offeror gets the price they ask for, those goods will trade hands -- regardless of why the bidder is buying.

When demand overwhelms supply -- as it has through most of April and May -- equity prices move up. As we saw in February and March, when supply is much greater than demand, prices go down. That's "Economics 101."

Knowing what factors are driving Demand may be helpful in formulating an investment thesis, but it does not change the basic Supply/Demand formula -- and that's what drives stock prices. Does it really matter if the buyers are big portfolio managers underexposed to equity and belatedly chasing performance, or if they are shorts covering their positions?

In the case of this last rally, the answer has been "not really." What's ironic about all the short covering chatter is that, even if true -- and surely, some percentage of the buying was short covering -- it's a net positive, not negative, for the overall market.

Why the "Short Covering Rally" myth is fundamentally flawed.

Consider the following reasons why. Whenever a "long" buyer purchases stock, it has an important effect: it temporarily removes some supply from the market. That supply then shifts into the pool of "potential supply" -- Shares which may be sold at a later date.

What's the significance of this? Except for Warren Buffett, most long buyers eventually sell their shares. As those shares are put up for sale, supply in that particular equity temporarily is increased. More supply (at the same demand level) means lower prices.

I am not, of course, referring to total supply -- the number of shares outstanding, or the liquid float which is actually traded, remains unchanged. Rather, I am alluding to the potential selling of shares in a given price range.

That's one of the reasons technicians use moving averages: it can help identify when a stock has run too-far-too-fast. Whenever an equity is 25% or so above its 50 day moving average, it often suggests that recent purchases (now in the pool of potential supply), will come back to the market as actual sales. The temptation to take a quick profit of a recent purchase is usually too great for many share holders. A stock up 15 or 20% in a few days comes back to the market as supply -- and THAT moves the stock price back towards its moving average.

As holders take profits, the selling of recent purchases puts pressure on stock prices.

Contrast that with the "its only short covering, not real buyers" story: Remember, shorts sell first and buy later. Since the short sellers have previously sold their shares, they have already added to supply. Their actions had already pressured prices -- prior to the short covering rally.

Their covering purchases is an increase in demand, without the commensurate increase in potential supply. In other words, these purchases do not come back and hit the market. Short covering does not cause near term profit-taking.

There is also an important psychological component: short covering suggests that some of the market's savviest participants may be changing their bias. After making a killing the past few quarters, short sellers -- typically large hedge funds and options professionals -- now may be getting bullish. Many of these players are not only covering their shorts, but turning around and becoming net longs.

That's a potentially bullish scenario.

Conclusion

Savvy investors should be aware of the short interest in stocks they have an interest in, as well as the broader indexes. In turnaround situations, shorts may be the last to recognize the fundamental changes for the better.

Very often, a new management team comes in, shakes the place up, and gets things back on track. Examples of those turnaround situations where there was a huge short interest are Apple (AAPL), Kmart (KM), and Whirlpool (WHR). Each of those stocks had tremendous short interest before new management changed the fundamental picture of the companies. Short covering helped drive the stocks higher.

Market cliches such as "only a short covering rally" are no substitute for rigorous analytical reasoning. Investors who rely on them do so at risk to their own portfolios.

Answer 2

When a stock is shorted & it starts to rise investors that are losing money have to buy back their shares. This action is considered "covering" their shorts.

The net effect is to add to the rising price of a stock. Barron's magazine reports the "short" interest in a stock. This is called a "short squeeze".  Their are many traders that make money looking for these opportunities.

On June 9th Barron's reported the top "shorted" stocks with the largest increases;

WACHOVIA

WELLS FARGO

ISHARES RUSSELL 2000

FANNIE MAE

BANK OF AMERICA

REGIONS FIN

WASHINTON MUTUAL

AIG

GE

AMR CORP

ETC.

After a major downtrend I look to these list for buying ideas.

(all of the above have increasing short interest. I would not use them for long leads).

Answer 3

There are investors who borrow stock shares from their broker and sell those shares in hope of buying them back after bad news causing a major drop in the company.  But, lets imagine that the stock has a break through drug approval from the FDA and the good news has other people buying the stock like crazy.   The short seller "the guy who borrowed shares from his broker and sold them" has to buy the shares he has "sold."  That is a short covering example.  Bottom line: you bet on a drop and the stock popped.  You have to get out of the "short position" or your loss will likely be greater.  The "rally" comes from  the short seller who is willing to sell fast and is not too concerned about getting the best sell price.  Just out of the short position.   It is the old story of good news or bad news feeding on itself.

Answer 4

Short covering rallys are when the people saying the market will drop begin to feel as though it might not...they rush to close out their positions by purchasing back the stocks they shorted.  Short cover rallys typically don't last long, however that's somewhat dependant on how large the overall short position is on the market place.  It's also somewhat dependant on weather the market is currently bullish or bearish.