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Can I profit from short-covering rallies?

I keep hearing commentators on business shows like yours on Sky Business talk about short-covering rallies. I thought shorting should take a market down not up into a rally. Please explain.

A short-covering rally happens when a large number of short sellers decide to take profits by covering their positions. The buying to cover is a protection of profit motive. However, their actions often can lead to more buying by others.

Here’s an interesting example.

There was a market rally that preceded the US attack on Iraq and experts say this was almost certainly a short-covering rally.

The Dow Jones and Nasdaq Composite had been falling since late January and were approaching new lows, and short sellers had been making great profits.

When some gutsy players came in and bought at the lows, the short sellers covered some of their positions and pocketed profits. This led to a chain reaction and other short sellers jumped in before their profits vanished.

Short-covering rallies often happen when bad news greets the market at the open. This brings in short sellers who then might take profit in the last hour.

Remember, short selling is the selling of a stock that the seller doesn't own. More specifically, a short sale is the sale of a security that isn't owned by the seller, but is promised to be delivered in the future. When you short sell a stock, your broker will lend it to you. The stock will come from the broker’s stock of stocks, that is, from another one of the firm's customers, or from another brokerage firm.

The shares are sold and the proceeds are credited to your account. Eventually you must "close" the short contract by buying back the same number of shares and this is called covering. This returns the stock to your broker.

If the price drops, you can buy back the stock at the lower price and make a profit on the difference. If the price of the stock rises, you have to buy it back at the higher price, and you lose money.

That’s why when good money is made on a down day or if some potentially good news looks possible, you can see a short-covering rally.

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.

For advice you can trust book a complimentary first appointment with Switzer Financial Services today.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published on: Thursday, June 03, 2010

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