Short covering refers to the purchasing securities to cover an open short position. It implies the actual purchase of securities or commodity by a short seller to replace those borrowed at the time of a short sale. To close out the position, the trader must purchase the same number and type of security that he sold short.
In order to make a profit on a short cover, one must buy the security at a price less than the price at which one sold it. It is also simply called a cover.
Lets elaborate to comprehend in detail. Traders sell a stock short because they believe the stock's price will fall in the future. However, if the stock's price goes up, the trader may choose to reduce or eliminate his exposure to a short position. This is called short covering.
For example, a trader shorts 1,000 shares of Bharti Airtel at Rs. 330 per share, believing the share price will fall. Instead, the price rises to Rs. 350 per share. To cover his short position, he will purchase 1,000 shares of Bharti Airtel at Rs. 350 per share. In this case, he makes a loss of Rs. 20,000 i.e. (350 – 330) * 1,000 shares. However, if price of Bharti Airtel had actually fallen to Rs. 300, the trader would have covered his short at that price and would have made a profit of Rs. 30,000 i.e. (330 – 300) * 1,000 shares.
Thus, Short covering helps traders protect themselves against potential losses if the market moves against them.