What is a Short Covering Rally?

Since the close of trading on September 28th, share prices in the energy sector have experienced a rebound every bit as vicious as the decline that preceded it. To take a sampling of returns as of pixel time:

  • Hess Corp (HES) + 29%
  • Occidental Petroleum (OXY) +16%
  • Marathon Oil Corp (MRO) +36%
  • Valero Energy Corporation (VLO) +13%
  • ConocoPhilips (COP) +23%

Whenever I observe quick returns like these after a sustained period of declining prices, I can’t help but think of a short covering rally. This type of rally can be more like a stampede. But what is a short covering rally, exactly? Why do prices tend to rally so hard and fast when shorts cover their positions?

To understand the answers to these questions, let’s make sure we have a solid grasp of what it means to short a stock.

Let’s start with something familiar: buying and then selling a stock, aka going long.

We can go long stock in 1 of 2 ways:

  • Buy it straight cash, i.e. your cash
  • Buy it with some of your cash and some margin (money lent to you by your broker)

At any given moment a percentage of all the people who are long stock have bought using margin. When you or anyone else uses margin, you are entitled to the profits and losses from the trade, but you don’t technically own the shares in a traditional sense. Your broker does.

Your broker likes making money, and he isn’t content with merely charging you a paltry interest on your margin account. No, no, he’s got bigger plans for the shares you bought.

A broker being a broker (kind of the original market maker), he’s going to look to find someone who thinks the share price will go down, call him Bob. Your broker is then going to lend Bob your shares and charge him money for the privilege. This is called stock loan and its a surprisingly important part of the stock market.

Those shares on loan to Bob are then going to be sold on the open market, making him short the stock.

Why is Bob doing this? The reasons are myriad, but he’s certainly not evil. In fact, Bob might not really want the stock he sold to go down much at all.

Say Bob is a hedge fund who has purchased a huge line of long cash and derivative positions in COP, like, way more than he could possibly sell without alerting the market to his position. He might then identify 5-10 liquid stocks using a Minimum Spanning Tree that are highly correlated with COP that he can short to hedge some of his long exposure. In this case he is just using the short as a cover to buy him time to dispose of his long COP exposure over a longer time-frame and without anyone noticing.

A short covering rally is different, however. When Bob sold those shares in the Energy sector short, he probably wanted the price to go down, a lot. He’s still not evil, remember, for him to be short in the first place some greedy short term trader had to borrow money to buy shares!

No, what makes a short covering rally unique is that in addition to Bob, Tom, Dick, Harry, Steve, and Randy also borrowed shares to sell short. So did Sally, Susie, and Samantha. They all sold it.

Remember, this is a two way street: for all these guys to short a corresponding amount of margin accounts had to make a bet that the sector would rebound. This is what makes a market, after all.

Then one day all the longs woke up and said “F*** it, I’m done losing money…” Then they do a quick calculation of all the things they could have spent their losses on that would have actually provided enjoyment (coke, cars, condos) and dump their shares.

The next day the shorts realize the cost of shorting has gone through the roof. Stock loan is a liquid object: the supply of stock to borrow ebbs and flows with the demand from margin accounts. So the price of borrowing a stock works like anything else: constrict the supply and the price goes through the roof.

Now the shorts are each individually faced with a decision that has collective implications: will this stock continue to go down enough to make it worth paying more interest on the stock loan? Actually, they might not even have that choice, however, if enough supply vanishes from the stock loan market brokers can call in the loan, forcing liquidation of short positions. In situations like this, a stock will usually go on a hard to borrow list.

Whichever mechanism is at work, these situations lead to rapid attempts to close out short positions. These buyers aren’t like normal longs: they aren’t really price sensitive. Buyers like this are placing orders with the intent to exit a position aggressively.

Moreover, since the environment for short covering rallies is usually created buy a prolonged period of negative returns, many short covering buyers may have large profits from position trading, making them care even less about a point or two on their exit.

All these factors combine to create a flurry of buying known as a short covering rally. This phenomenon is self-correcting however: the crescendo of rapid buying eventually entices margin buyers back into the market. This has the effect of resupplying the stock loan market, thus abating the catalyst of the event.

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