Definition

• Buying back the shorted stock is called closing out, or covering, a short position. There are several reasons for short covering.
  
  

Stop Loss

• The most popular misconception about short selling is the possibility of an unlimited loss because theoretically any stock can go up to infinity. In reality, this is virtually impossible as no stock goes to infinity overnight, and there is no reason for a short seller to sit and watch his losses grow. When a trader sells a stock short, he determines the maximum amount of loss he is willing to accept if the trade goes against him, i.e., if the stock rises instead of falling. Once the stock reaches that limit, the short seller buys it back to cover his short position.
  
  

Taking a Profit

• A shorted stock can go down to zero, and some do, but more often a period of a steep decline ends and a short seller's profit stops growing, so he covers his position to realize a profit.
  
  

Buyout

• Unlike investors who can hold the stocks they bought outright indefinitely, short sellers must cover, or return the borrowed stock, at some point. Sometimes they are forced to do that in a buyout. A falling stock price makes a company an attractive acquisition target. Usually, a buyer offers a premium over the current stock price to induce current shareholders to sell. A buyout often makes a stock gap up -- open at a much higher price than it closed the day before. A gap up often means a loss for short sellers, who are forced to cover because it no longer makes sense to keep a short position in a stock that has been bought out by a stronger competitor.
  
  

Short Squeeze

• Short sellers can only cover their positions when there is enough stock for sale. If little or no stock is available, short sellers panic and scramble to cover at any price, causing a spike in the stock price. Big traders know that and periodically create "short squeezes" in heavily shorted stocks by temporarily limiting or withdrawing offers to sell. This typically is done when a company announces positive news, and buyers step in to buy at the depressed price levels. The short sellers see the good news, the buying, and rush to cover their positions.