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How to Judge Short Covering

The stocks in the short term gyrates due to demand supply situation. Several factors contribute to vigorous movements of High Beta stocks or in other way it could be said that the volatility measure or Standard Deviation of these kinds of stocks would be high. Technical Analysis indicators come handy for these kind of stocks.

Traders try to take positions on either side and the view changes quickly, price spikes are natural and sudden as well as the carnage. Stock prices could change due to majorly two factors:

  1. New Information has come in about the stock so the analyst try to adjust the numbers and then decides their strategy based on price target
  2. The traders are caught on the wrong side of the trade and try to get out of the trade – when the market has huge short positions created a simple 2-5% move might unnerve many investors and trigger a Short Covering

It is important for a trader to know whether the Price action is due to renewed interest in the stock and people are ready to buy at higher price or its the traders who are covering their shorts.

As in the former case the up-surge is sustained for a longer time frame and for a larger change.The traders should be comfortable in buying in such a scenario even if they have missed buying at lower levels.

In case of Short Covering the traders need to be more careful in buying as once the shorts are covered at higher levels, the stock might retrace back and give up some of the gains. Traders would have bought the stock at the higher level and trapped.This is also known as Short Squeeze, when one buys with a false signal of breakout which was originally a Short Covering.

So how to make out whether the upward surge is due to Short covering. An easiest way is to see the Open Interest going down substantially with a strong movement in price.Let us see an example for a rise of 2.6% in Pantaloon Retail today

Current OI Change % Chg
Future
7,818,000 -716,000 -8.39%
Call
1,496,000 132,000 9.68%
Put
696,000 68,000 10.83%
Total
10,010,000 -516,000 -4.90%

The Open Interest in Futures has gone down by 8.39% showing massive short covering and hardly new buying has been made. Rather despite such a strong move there were more calls being sold at higher levels than puts, indicating the stock should face resistance at elevated levels

For positional shorters, they will keep the position intact after studying these figures if they can bear the Margin call but the weaker hands and Algo traders will get out as their stop losses would be hit.

Would appreciate some comments on the usefulness of this article.

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