What is a short blanket?
Short hedging refers to buying back borrowed securities in order to close out an open short position with a profit or loss. This requires the purchase of the same title as the one originally sold short, and return the shares originally borrowed for the short sale. This type of transaction is called buy to cover.
For example, a trader sells short 100 shares of XYZ at $20, based on the belief that those shares will fall. When XYZ declines to $15, the trader buys back XYZ to cover the short position, reserving a profit of $500 on the sell.
Key points to remember
- Short hedging involves closing a short position by buying back shares that were originally borrowed to sell short using buy orders to cover.
- Short hedging can result in either a profit (if the asset is repurchased at a lower price than it was sold) or a loss (if higher).
- Short hedging can be forced if there is a short squeeze and sellers are subject to margin calls. Short-term interest measures can help predict the chances of a tightening.
How does the short cover work?
A short hedge is needed to close an open short position. A short position will be profitable if it is hedged at a lower price than the original trade; it will incur a loss if it is hedged at a higher price than the original trade. When there are a lot of short hedges on a security, it can lead to a short presswhere short sellers are forced to liquidate positions at progressively higher prices as they lose money and their brokers invoke margin calls.
Short hedging can also occur unintentionally when a security with a very high short interest is “buy-in”. This term refers to a broker closing a short position when the stock is extremely hard to borrow and lenders demand it. Often this happens in less liquid stocks with fewer shareholders.
Short interest and short interest ratio (SIR)
More the short interest and short interest rate (SIR), the greater the risk of a short hedge occurring in a disorderly fashion. Short coverage is usually responsible for the initial stages of a rally after a long bear market, or a prolonged decline in a stock or other security. Short sellers generally have shorter term holding periods than investors long positions, due to the risk of uncontrolled losses in a strong uptrend. Therefore, short sellers are usually quick to cover short sales on signs of a reversal in market sentiment or a security’s bad fortune.
Example of a short cover
Consider that XYZ has 50 million shares outstanding, 10 million shares sold short, and an average daily trading volume of 1 million shares. XYZ has a short interest of 20% and a SIR of 10, both of which are quite high (suggesting that short hedging might be difficult).
XYZ loses ground over several days or weeks, further encouraging short selling. One morning before they open, they announce a major client that will dramatically increase quarterly revenue. XYZ spreads are higher at the opening bell, reducing short sellers’ profits or increasing losses. Some short sellers want to exit at a more favorable price and refrain from hedging, while other short sellers exit their positions aggressively. This messy short cover forces XYZ to head higher in a feedback loop that continues until the short squeeze is exhausted, while short sellers waiting for a beneficial reversal suffer even greater losses.
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