Short covering is a purchase of stock bought to cover a short. Short covering is an investment term used by sophisticated investors who engage in the practice of buying short. Buying short means borrowing stock to sell in the hopes that the price of the stock will drop.
Shorting the market is an investment move that is made when a buyer believes the price of a security is about to go down. The investor will borrow some shares of the stock and sell them at the current market price. The borrowing doesn't occur from any one individual; the investor simply tells his broker to "buy to short" or selects that option himself from his online discount broker.
The investor at some point must cover his position by buying shares of the stock that he sold short. In other words, he has to buy the shares that he owes to whomever he borrowed them from. This process is called short covering.
The investor hopes to be able to buy those shares when the price of the stock has fallen. For example, assume the price of a stock is $15 US Dollars (USD) and the investor puts in an order to short 100 shares of the stock. In effect this means he is borrowing 100 shares and then selling them for $15 USD, without actually owning the shares.
If the stock then goes down to $14 USD per share, the investor can cover his short and buy the stock at that point. He will only have to pay $14 USD for something that he sold for $15 USD. This means he makes a profit of $1 USD per share, or $100 USD total.
If the stock goes up, however, the investor will still have to cover his short. In this case, short covering results in a loss. The investor will have to determine at what point he wants to cover his short; he has the potential to lose a great deal of money if the stock rises dramatically in price before he covers his short.
For example, assume that the investor shorted the same $15 USD stock. This time, however, the stock goes up to $20 USD per share. The investor decides that he must cover his short at that point. Short covering costs him $5 USD per share, because he must pay $20 USD for something he only sold for $15 USD.
