In your newsletter [on February 14] you talked about short covering as you have in the past. Just what does SHORT COVERING mean? (February 15, 2001)
When traders are bearish on the market they play the fall. They either sell stock they do not own and hope to buy it back at a lower price and pocket the difference, sell calls on stock they do or do not own, or buy puts. In the first scenario, when stocks that have been falling suddenly find support and start to rally fiercely, those that sold the stock often want to close out positions and pocket their profits before things get out of hand. Problem is, there is demand for the stocks all of the sudden in addition to those wanting to close short positions by buying the stock back. In other words, buyers are out there who want to own the stock for upside potential, and they are bidding the price higher. As short sellers compete to buy the shares, the price rises, and that forces more short sellers into action and this can cause dramatic price increases in a hurry. The more short interest, the more fierce the action can be.
With options we can see that action in puts: those who have bought puts start to unload them when it appears the market is ready to bounce up. Thus sometimes we can see a spike in the put/call ratio as put buyers close out their positions when the market starts to turn. If we see the market turn and a correspondent increase in put activity, we can assume some of that was related not to investors betting against the market, but bears closing out put positions. What we like to see for the put/call ratio is a day when it spikes over 1.0 and there is no real reversal in the market that session. That shows that put buyers were entering the market betting on further declines, and they were in the majority. That is usually an indication a move down is about to end.
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