In the previous article, we have seen about short selling and what are the risks involved. As promised in the last article, let us see how to mitigate the risk associated with short selling. We shall look at this with an example.
Trader Ram, borrows 50 stock of company XYZ at Rs 100 and promises to give back the stocks to the lender in a months time. Ram anticipates that the stock price of the company would go down to 80 rs and he is planning to buy back the share at 80 rs. Unfortunately , due to external and market conditions, the stock price of the company XYZ rallies to Rs 120 and there is only 3 more days for the month end and Ram has to buy back the shares and deliver it to the lender.
So Ram is in a loss of 20 rs/share and he has only 3 days to go and the market sentiment is very bullish and the stock price of company XYZ can appreciate further. Hence Ram decides to trim his loss at 20 rs/share and buys the share at 120 rs. Share market is not a place with only Ram as a short seller. There are numerous short sellers in the market and say 500 people had short sold the stock of company XYZ. All of them would be trimming their losses and all of them would be buying at higher stock price of 120 rs.
When 500 people places buy order for company XYZ at 120 rs, the company's stock price will eventually go further up and this increases the stock price of the company. This entire process is called "Short Covering". Short covering will lead to a rally in the overall market and these are called short covering rallies. When most of the traders had predicted that the market will touch lower levels, due to some global cues or other factors if the market rises, we tend to see the short covering rally.
The practises of short selling and short covering only suits traders and investors should try to stay away from risky practises.