What Do You Understand By The Term Short Covering?
Short covering is a tradition of buying securities to cover an open short position. When a trader chooses to close out a futures contract, he/she purchases the exact number and types of shares that he/she had been selling short. Short covering enables the traders to secure themselves against the potential loss that they undergo if the stock market moves against them. The short covering system puts the trader back in the market with a stable position, and it is a common practice among the traders.
How Do You Explain Short Covering?
If the short position in the market is covered at a lesser price than the stock was sold at, the short-sale will be beneficial. If the short covering happens at a higher rate than the stock was shorted, the result will be a complete loss. When you purchase a futures contract later in future at a lower price, the short seller can replace your part of the shares for less than the original one’s proceeds and profit from reducing stock prices. Purchasing the stock back to replace the carrying shares is called as covering a short.
Brief Explanation
Imagine that the price for a particular share of a stock has immediately risen too far and you think a pullback to the stock is required at this moment. To profit from the reduction in that particular stock, you need to enter a short sale order for about 1,000 shares of that stock to your dealer. To implement this order, your dealer needs to find a customer who has an account in that respective stock and sell these shares at a reliable price, for example, Rs 50 per share. Now, the total amount proceeds to Rs 50,000. If the price of the stock reduces to Rs48 in a month, you can tell your dealer to cover this position, and the dealer would then use Rs 48,000 of the original sales and buys 1,000 shares. He adds the amount in the original account and after deducting the commissions will give you Rs 5,000. It is certainly a handsome amount of profit for a month. If you have mistaken in your assessment and the particular stock shares it advances to Rs 52, you need to pay Rs 5200 to purchase back the 1,000 shares and this way your Rs 5,000 and the commissions will be your ultimate loss.
Nifty Future and Short Covering
Nifty future is generally traded in India, and the underlying asset is the benchmark index of NSE. It is based on the market price of the NSE built securities. The Nifty future is the purest form of the derivative; you can certainly trade in a future contract only by providing a total value of 8% as the SPAN margin.
Tenure at Nifty Future
The maximum time for the nifty future contract is about three months. You can buy a contract in the month of January, and it will expire in March. You need to buy or sell the minimum amount of 1 lot that contains 75 units and to trade in the nifty future; you need to have a trading account with a SEBI.
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