Short-Covering Rally
A short-covering rally is a more orderly event in which a large number of short sellers decide to take profits by covering their positions. The buying to cover often leads to more buying. It can produce a wild short squeeze, but in most cases the action is milder.
You’ll see a short-covering rally in many beaten-down stocks. The greatest impact, though, is seen when the DOW or NASDAQ moves higher as loads of shorts head for cover.
For example, the market rally that preceded the US attack on Iraq was almost certainly a short-covering rally. The DOW and NASDAQ had been sliding since late January and were approaching new lows. Short sellers had made outstanding profits.
Then a few early-bird buyers stepped in to spark a big open on March 17. The shorts took that market strength as a cue to cover some positions and lock in profits. As more and more shorts bought shares to cover, the DOW and NASDAQ surged higher, attracting a horde of buyers who did not want to miss the move.
A typical short-covering rally occurs in the final hour of a market session. If bad news or some other development hits the indexes at the open, short-sellers often hop on the downward momentum and push prices lower. By 3 p.m.
ET the DOW could be down 100-plus points.
More often than not, the indexes will stage a comeback in that final hour. Short sellers who have made a tidy one-day profit cover their positions, and that usually produces a spurt of buying. It tends to fizzle out in the last few minutes before the close when the momentum players are out and outright sellers again take control.
Day traders and other savvy investors look for signs of a late-day short-covering rally as an opportunity to grab some index-tracking Exchange Traded Funds (ETFs) like the DOW "Diamonds" (symbol DIA) or the NASDAQ 'Qubes" (symbol QQQ), or some "e-mini" futures contacts on the S&P 500. If the rally runs true to form, the momentum players are out before the closing bell, and hoping a few bucks richer.
You, too, should keep an eye out for short-covering rallies when you’re looking to buy or sell stock. They can be helpful in timing your order.
Larry Potter
Disclaimer
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