Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
CM Strategy

Optionalysis: What does "Short Covering" Really Mean?

CapM Premium Header

Firstly, we’d like to announce that we raised a round of seed funding for Capital Mind. Thanks very much for all your support and we hope to bring you greater and better things as we go along.

Continuing in the lines of our TA and Optionalysis posts, we’ll demystify the terms they use to describe the F&O market action:

[level-capmind-pro]

• How do they tell if it’s “Short build up” or “Long Unwinding” in stocks

• How useful are these metrics in a trade?

One of the things we keep hearing on TV and in other places is: This stock is seeing “short covering”, “profit booking” or “long build up”. This is strange, because for every buyer in the market today, there is a seller. How then can you say there is a “long build up” versus a “short build up”?

These terms apply largely to the F&O market. You can’t easily go short stocks in India.

In the F&O market, every contract has a buyer and a seller. The total number of open contracts is the “Open Interest”. Now let’s say there is just one contract between Deepak (buyer) and Rajeev (seller).

Tomorrow multiple things could happen:

• There could be a new buyer and seller in the market, who create another contract. This increases the total open interest to 2 contracts.

• A new buyer could come in and Deepak could sell his “long” part of the contract. The number of contracts are the same (1) but one buyer has been replaced with another buyer.

• Similar thing for a new short seller replacing Rajeev.

• Deepak and Rajeev could close out the contract, where Deepak sells and Rajeev buys. The number of open contracts falls down to 0.

What happens then with respect to open interest is – it could increase, decrease, or remain the same. This is not helpful, we know.

But what is helpful is: How does the price react?

The Price-OIChange Combinations

If the price increases, and the open interest goes up, then someone was willing to buy the future at a higher price. Additionally, since the OI went up, it wasn’t like existing holders were selling at the higher price (if they were, the OI would remain the same). New buyers were coming in, and new sellers were coming in too, at higher prices.

Effectively there was a long build up, or buyers willing to pay higher. This is reflective of anincrease in open interest and increase in price.

Let’s say the same thing happens to the price – it goes up – but the number of contracts remains the same or reduces.

Now in an increasing price scenario, there’s one person seeing losses – the short side or the “sellers” of futures contracts. This person could have said “enough” and booked losses – while some of the long positions decided to book their profits instead. This is called Short Covering (orprofit booking) when the price goes up but the OI goes down.

What if the price falls?

• If the price falls and OI goes up, there are more contracts being created. This is a “short build up” as it indicates interest on the sell side.

• If the price falls and OI goes down, it’s a “long unwinding” where your long positions are booking their losses.

Why Not The Other Side?

A Long Build Up can easily be a short build-up too, since there are as many new sellers as new buyers. A Short-Covering is similarly equal to a “profit booking” for the long side. This is true, and can be argued like this.

Which is why you only take extremes – that is, big jumps in OI and big jumps in price. That shows you the selling pressure was high when prices were falling, which took the price down a lot. That tilts the equation towards the side of the story our terms explain.

Show Me: The Lists As Of Today

Let’s take some examples. We add up all the futures contracts (only futures, not options) and check out the OI differences in the previous two days. Here’s what we get for “Short Covering” today (01 Apr 2015):

Short Covering

Ignore Ranbaxy, as it goes out of the system today and merges with Sun Pharma, and the unwinding of shorts could be because Ranbaxy’s short positions exit as there will be no further trading in Ranbaxy.

The rest show a pattern – a sharp rise in the price with a sharp change in open interest. Many of these stocks show that they have been short candidates because they have been continuously falling, and eventually a rebound took the weak hands out of the system. Look for instance at SAILs chart:

Sail

The strong support at 66 threw out short sellers, as the price went up over 5%. It’s interesting to see this, as it’s possible the “bounce” was purely because many of these short sellers decided it was enough to see this level hold and cut their positions.

Here’s the Long Build Up List:

Long Build up

Interestingly, both IDEA and Century Textiles have made new highs and are part of our Outliers screens. The fact that they are building up long positions and are not “short covering” further cements their breakout as strong.

Here’s the other two types:

Others

On a day like April 1 when the index went up more than 1% you will not find many stocks that see shorts build up, or Long Unwinding. But the fact that these stocks are going down in a big upmove is indicative of their weakness.

How does we use this?

What we can see here is a short term pattern (of just one day). We have made the lists meaningful – a move in price of at least 1% and a reasonable change in Open Interest. Also we have added up all futures contracts (near, mid, far) for each stock.

But all this is just explanations in hindsight. How can we use this information going forward? The lists above surface certain elements:

• SAIL – we see the chart above and understand this may become a useful long position with a strong stop loss below 66. The short covering resulted in only a 4% drop in OI, which means an further upmove will see more covering (and thus take the price up further)

• Century Textiles and IDEA are making new highs, and also seeing a strong Long build up. This is a positive trend indicator – saying that this new high isn’t seeing people book profits (otherwise, OI would have fallen and shown up as short covering).

• Maruti’s fall – on the news of its slowing growth and sales – is not seeing the building of large short positions, as the OI is not increasing as the price calls. Which means the fall is likely to be temporary. A position here would be to go long if the stock continues to be a “long unwinding” on Monday.

More importantly, we could see a turn in trend here – after many days of Short Build Up a stock might move suddenly into the Short covering category. This provides a key input into the trend change that might be visible on the charts.

It is also useful to see the change in open interest in a price over a marginally longer term, not just overnight. A 5 day change gives a trader a better handle of whether there is really a trend change or otherwise. The F&O players reveal their hand through not just the change in price, but also the change in Open Interest.

Where can you see this information?

While we are building this into Capital Mind Premium’s data analytics site, that’ll still take a while. Till there, here’s a link to IIFL’s web site which shows some of these metrics, though they don’t do multi-day changes. This article expects to help understand these terms; for a better reasoned trading strategy a lot more research and work on data is required, which involves doing more sustained back-testing, so please don’t use this information as a primary source for trading. At best, it will be a secondary confirmation or rejection of a position that comes from chart study or Outlier analysis.

divider

Disclaimer

Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion. 

Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.

Capital Mind for ZD

[/level-capmind-pro]