How does short covering in futures/options lead to a rally in the underlying?

F&O
1

I often hear that short covering in futures or options can lead to a rally in the underlying.

My understanding is that when traders cover short futures positions (option positions), futures (synthetic future) prices may rise. So arbitrageurs may buy the spot and sell futures, which could create buying pressure in the cash market and contribute to the rally.

Is this understanding correct? Or are there other mechanisms through which short covering in futures/options causes the underlying price to rise?

2

Short covering itself doesn’t create new demand for the underlying stock. It happens when traders who had short futures/options positions buy them back to exit. That buying pushes futures prices up, and if it happens on a large scale, it can also attract buying in the cash market, leading to a rally in the underlying.

3

it can also attract buying in the cash market >> u mean arbitrage ?

4

Yes, arbitrage is one part of it. It can also attract fresh buying as sentiment improves.

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