Discerning the difference between short covering and real buying

When a market has been bullish for a while, there is a tendency to see sharp short covering spikes occur. They are driven by nervous shorts who run for cover thinking that maybe they are wrong again as well as over anxious bulls who want to call the bottom. The difficulty is determining whether a snapback against the trend really has staying power or is simply a short covering rally that is destined to fail.

There's no hard and fast way to determine which is which, but the proof of the pudding is usually found in the volume. A short covering rally will look just like a lasting move in that volume on the way up will gather strength and crescendo with a nice increase over recent volume. That part looks the same. What is typically not the same is how things look on the way back down and the subsequent attempt to push higher. If you high volume on the way back down or less volume on the secondary attempt to push higher, you are likely witnessing a short covering rally and nothing more.

Although there are other sign posts to look for like, the quality of the rally (is it broad or narrow), whether it is driven primarily by futures buying, whether it is centered in speculative stocks mostly, etc., paying attention to the volume story is the most critical factor to observe.