Buy to Cover: A Strategic Move in Stock Trading
Buy to cover refers to a buy order made on a stock or other listed security to close out an existing short position. A short sale involves selling shares of a company that an investor does not own, as the shares are borrowed from a broker but need to be repaid at some point.
Key Takeaways
- Buy to Cover refers to a buy trade order that closes a trader’s short position.
- Short positions are borrowed from a broker and a buy to cover allows the short positions to be “covered” and returned to the original lender.
- The trade is made on the belief that a stock’s price will decline, so shares are sold at a higher price and then bought back at a lower price.
- Buy to cover orders are generally margin trades.
Understanding Buy to Cover
A buy to cover order of purchasing an equal number of shares to those borrowed, “covers” the short sale and allows the shares to be returned to the original lender, typically the investor’s own broker-dealer, who may have had to borrow the shares from a third party.
A short seller bets on a stock price going down and seeks to buy the shares back at a lower price than the original short sale price. The short seller must pay each margin call and repurchase the shares to return them to the lender.
Specifically, when the stock begins to rise above the price at which the shares were shorted, the short seller’s broker may require that the seller execute a buy to cover order as part of a margin call. To prevent this from happening, the short seller should always keep enough buying power in their brokerage account to make any needed “buy to cover” trades before the market price of the stock triggers a margin call.
Buy to Cover and Margin Trades
Investors can make cash transactions when buying and selling stocks, meaning they can buy with cash in their own brokerage accounts and sell what they have previously bought. Alternatively, investors can buy and sell on margin with funds and securities borrowed from their brokers. Thus, a short sale is inherently a margin trade, as investors are selling something they do not already own.
Trading on margin is riskier for investors than using cash or their own securities because of potential losses from margin calls. Investors receive margin calls when the market value of the underlying security is moving against the positions they have taken in margin trades, namely the decline of security values when buying on margin, and the rise of security values when selling short. Investors must satisfy margin calls by depositing additional cash or making relevant buy or sell trades to make up for any unfavorable changes in the value of the underlying securities.
When an investor is selling short and the market value of the underlying security has risen above the short-selling price, the proceeds from the earlier short sale would be less than what is needed to buy it back. This would result in a losing position for the investor. If the market value of the security continues to rise, the investor would have to pay increasingly more to buy back the security. If the investor does not expect the security to fall below the original short-selling price in the near term, they should consider covering the short position sooner than later.
Example of Buy to Cover
Imagine a trader opens a short position in stock ABC. After analyzing the company’s financials, they realize ABC’s stock price, currently trading at $100, is likely to decline due to signs of financial distress. To profit from this, the trader borrows 100 shares of ABC from their broker and sells them at the current price of $100.
As anticipated, ABC’s stock falls to $90. The trader then places a buy to cover order to buy back the 100 shares at the new, lower price and returns the borrowed shares to the broker. This move nets the trader a profit of $1,000: $10,000 (sale price) - $9,000 (purchase price).
Related Terms: short sale, margin call, broker-dealer, buying power.
