What does “Buy to Cover” Mean? Example, Overview, 10+ Facts

Speculating on a stock’s price drop may result in a profit if you sell it short. In a word, short selling is the process of borrowing stocks from a broker and then selling them on the open market.

Simply selling the stock allows you to execute the transaction and finish out your stake. Closing a short position takes greater effort. To close a short deal, the borrowed shares must be returned to the broker.

As a result, the investor who borrowed the stock must now buy it back, hopefully at a lower price than when it was borrowed.

Short covering, also known as buying to cover, is the process of acquiring shares on the open market to cover a short position.

What does “Buy to Cover” Mean?

To cover a short position, a “buy to cover” order is made to purchase a stock or other listed securities. When an investor makes a short sale, he or she is selling shares of a company that they do not own.

What does "Buy to Cover" Mean?

Instead, the investor borrowed the shares from a broker and will be responsible for returning them at some point.

Understanding Buy to Cover

If the investor’s broker-dealer needs to borrow the shares from a third party in order to complete the short sale, a “cover” order can be made to have the equal number of shares acquired returned to the investor.

A short seller is someone who sells shares of a firm with the hope that their value will fall and then tries to buy them back at a lower price. The short seller is required to meet each margin call by acquiring and returning the shares from the lender.

A short seller, in instance, may face a margin call from their broker if the stock price continues to rise above the price at which the shares were shorted.

The short seller can prevent this by keeping enough money in their brokerage account to cover any “buy to cover” trades that are required before the stock’s market price triggers a margin call.

Buy to Cover and Margin Trades

A trader can buy stocks using cash in their brokerage account, and the same is true for selling stocks they currently own. Investors can also utilize cash and assets borrowed from their brokers to execute purchases and sells on margin if they like.

A short sale is a margin transaction by definition since investors are selling a securities that they do not physically own.

Trading on margin is riskier for investors than trading with cash or their own stocks because of the danger of loss from margin calls.

Margin calls are delivered to investors when the underlying asset’s market value changes against their positions in leverage trades, such as when the value of the securities falls when they buy on margin or increases when they sell short.

If the underlying stocks’ value falls, the investor will receive a margin call and will need to deposit more cash or execute appropriate buy or sell trades to restore the initial margin level.

What does "Buy to Cover" Mean?

When the underlying asset’s market price climbs above the short-selling price, the investor’s gains from the first short sale will not be enough to pay the cost of repurchasing the security.

If this occurred, the investor would have a negative net worth. If the market value of the asset continues to rise, the investor will have to pay a greater and higher price to exit.

If the investor does not foresee a price decrease in the security that would bring it below the original short selling price, they should consider completing their short position as soon as feasible.

Example of Buy to Cover

Assume a trader opens a short position on ABC stock. Based on their findings, they expect ABC’s stock price will fall from its current level of $100 over the next several months owing to warning indicators in the company’s financials.

To achieve a return on their thesis, the trader borrows 100 shares of ABC from a broker and sells them in the open market at the current price of $100.

When ABC’s stock price falls to $90, the trader issues a “buy to cover” order to repurchase 100 shares from ABC at the lower price and return them to the broker.

To prevent a margin call, the trader must place a purchase to cover order ahead of time. The trader earns a $1,000 profit ($10,000 sale price less $9,000 cost basis) (purchase price).

How Does A “Buy to Cover” Works?

We can better demonstrate the operation of the buy-to-cover order using this example. Assume the existence of Company X.

Because the stock price has failed to reflect these considerations, you, as a trader, assume that the company is either overvalued or that its financial situation is deteriorating. Your trading experience has taught you that the stock price of Company X will almost surely fall.

As a trader, you may profit from the aforementioned scenario by simply placing a short sell order on the stock. Because of the short sale order you just made, your broker will lend you the shares to sell on the market.

When you notice that you are gaining handsomely from a dropping stock, you decide to liquidate your position by executing a purchase to cover order. You can conclude the trade and pocket your earnings by using a limit or market buy-to-cover order.

Recognize that the use of margin, which is required for shorting, increases your risk. This is due to the danger of financial loss posed by margin calls from brokers.

It is fairly unusual for investors and traders to receive a margin call if the stock price falls against them.

What does "Buy to Cover" Mean?

Advantages of Buying to Cover

After all, the chance of profit is the most important aspect of every deal.

Profiting from a short sale is forbidden unless you also purchase enough inventory to repay the debt. You can’t just go shopping and go.

When taking profit or pulling out, you must purchase to cover. Closing a deal, whether on the winning or losing side, is always a relief.

Tension, whether excited or worried, is an inevitable byproduct of working in a trade. It’s over when you eventually give in to the pressure. The uncertainty is revealed. Simply said, you may proceed.

Disadvantages of Buying to Cover

When shares are traded, the available supply increases. This might cause the stock price to fall. Actually, not bad for a short seller.

Purchasing covers is the same as making a standard purchase order. When a big number of people make a purchase at the same time, there is a surge of demand. This might reduce your earnings. The worst-case scenario.

When numerous short sellers seek to exit the market at the same time, this is referred to as a “short squeeze.” People are looking to buy in order to close open holdings. The cost rise corresponds to the rise in demand.

All of this ambiguity implies that the magnitude of our investments will have little impact on the stock’s price. Prices can change quickly in reaction to public perception.

Price instability makes it difficult to bargain for the best offer.

Is buying to cover risky?

The procedure of “buying to cover,” or acquiring enough shares to finish a short position, is risk-free; nevertheless, shorting a stock is.

As an investor, the most you can lose on a stock you buy entirely is the amount you paid for it, because the stock’s lowest possible price is $0. Because the maximum price of a stock is not predetermined, short sellers’ potential losses are theoretically limitless.

Shorting a stock has little upside potential because the lowest stock price is zero. While selling a $50 stock yields a maximum gain of $50, direct ownership of the same item can provide significantly more than $50. Only by physically owning stock can you grasp its full potential.

The Importance of Buying to Cover in Day Trading

Most people who invest in blue chip companies do so with the intention of owning them for the long term.

Short selling is less frequent than long-term investing. Long-term stockholders are not short-term traders. Most don’t survive more than a few weeks. Short sellers typically buy intraday to cover their bets.

When looking at the main indices over longer time periods, the market is growing. Corrections and bear markets are examples of short-term patterns.

What does "Buy to Cover" Mean?

As a result, short selling is not a long-term investing strategy. You’re aware that you shouldn’t go against the grain of the market as a whole, aren’t you?

Furthermore, while short selling, you borrow shares from your broker. Do you believe you can keep them for free indefinitely? We can immediately rule it out.

Even holding onto lent shares for a single day incurs interest charges. Stocks that are heavily shorted and in great demand are more costly to borrow against. As such expenditures rise, they can eat away at any earnings that could otherwise be produced.

Sell Short vs Buy to Cover

Buying to cover a short position is only one side of the “selling short” transaction. A short sale is when an investor predicts a drop in the value of a stock or investment and sells shares borrowed on margin, generally through your broker or dealer.

To complete a short sale, an order to “buy to cover” could be placed. When you do this, the underlying shares you sold will be repurchased at the current market price or the price set in your buy-to-cover limit order.

If the stock price has dropped as projected, you can profit by selling high and buying low.

Buy to Cover and Margin Trades

Short selling and margin trading are closely linked to the use of a purchase to cover order. Margin trading is a financial technique used to sell shares that you do not yet possess.

A buy-to-cover order is issued when a trader is ready to liquidate their position by purchasing the same amount of shares that were sold on margin.

Remember that if the stock price swings against you after a short sale (by increasing instead of falling), your broker may issue a margin call, compelling you to either sell your stock or deposit additional cash to cover your shorted shares.

Short Covering and Buy to Cover 

Are They the Same?

Short covering is the process of exiting a short position and returning borrowed shares to your broker. “Buying to cover” a short position is one definition of “covering.” Both statements imply that you are exiting your short position.

What does "Buy to Cover" Mean?

What’s the Difference Between Buy and Buy to Cover?

Most individuals understand how to make money by purchasing low and selling high. This is the standard in the financial markets. To begin a purchase, choose the required number of shares and enter the desired purchase amount in the order box. Isn’t it simple?

Covert buying is a very different beast.

When one buys to cover, it is not a position entry. You’re going now. As I have stated, short selling necessitates the borrowing of shares. If you just buy to cover a position, you will wind up with no shares. They are returned to your broker.

Buy to Cover: Frequently Asked Questions

Let’s go over some frequently asked questions about buying to cover…

What Does Buy to Cover Mean?

A “purchase to cover” order must be issued in order to finalize a short sale. To “short” a stock means to “borrow” it at a high price with the anticipation that it will decline in value.

Even holding onto lent shares for a single day incurs interest charges. Stocks that are heavily shorted and in great demand are more costly to borrow against. As such expenditures rise, they can eat away at any earnings that could otherwise be produced.

How Do You Cover a Short Position?

To close off your short position, you must submit a purchase order. This is because short selling means selling shares at a higher price and then repurchasing them at a lower price. You hope to earn as the share price declines.

What’s Buy to Open and Buy to Close?

When you acquire shares to start a position, you are making your initial investment in the stock. A buy is required to close a short position. To complete a short sale, you must first sell your asset and then find a replacement.

What’s Sell to Cover?

There is no such thing as “sell to cover” in the realm of day trading. Concerning the utilization of stock options provided by an employer. Employees sell stock options to offset the expense of purchasing business stock.

How Does a Stop Limit Work With a Buy to Cover Order?

A stop-limit order, like a long position, can be used to close a short position.

We’re discussing a buy stop limit order here. A buy limit order specifies the lowest price at which you are ready to acquire a stock.

When the trigger price is reached, your order becomes a limit order at the price you requested, and it should be executed if there are willing sellers to match your demand.

How Long Do Short Sellers Have to Cover?

After a short position is opened, there is no time limit on how long it can be kept.

The length of time you retain shares is determined by the interest rate you are willing to pay. And, as previously said, the costs may grow if borrowing demand rises.

The phrase “short squeeze” refers to what happens when favorable news regarding a stock that has been heavily shorted is disclosed. Brokers will begin purchasing shorts if they do not buy to cover their positions.

What does "Buy to Cover" Mean?

This is due to the fact that shorting might result in limitless losses. It is possible to lose more money than you first invest while trading. As a result, if your loss grows too large, your broker will close your deal. Furthermore, the loss is yours to bear.

As a result, inexperienced traders should avoid short selling. A low-balance account can soon run out of funds. Disciplined traders should avoid this strategy to the greatest extent feasible. If you find it difficult to give up. Short selling is not permitted.

How Do You Know If You’re Short Covering?

To short cover, you need a short position. A buy order is simply an order to purchase shares in the absence of a short position. Furthermore, if you are short a position and place a buy order, your short position will be liquidated.

Assume you are short 100 shares but unintentionally submit a buy-to-cover order for 200. Your short position of 100 shares will be covered and converted into a long position of 100 shares.

How to Identify a Short-Covering Rally in Stocks

If shorts cover their holdings, the price of a stock will skyrocket. There is no need for a news conference or an announcement.

A quick squeeze might be a sudden, steady price increase or a slow ascent in which each decrease is purchased.

The time and sales books will be filled with green as shorts cover at the ask price to exit their holdings. When a stock breaks out to new highs, there is an upsurge in interest from long traders.

How Does Short Covering Affect Stock Price?

It’s important to remember that the market doesn’t care if you’re just buying or purchasing to cover. The only alternative, in their views, is “buy.”

The market is built on supply and demand. Purchase is synonymous with market demand. So it makes no difference if there are a large number of purchasers or shorts purchasing to cover. The price is growing.

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Conclusion

To “buy to cover,” a market order is placed to return previously borrowed shares utilized in a transaction to their original lender, therefore closing a short position.

This activity is necessary for the trade to be completed and may be imposed as part of a margin call if a broker is concerned about a borrower’s capacity to repay a share loan.

To purchase the appropriate number of shares, one can either utilize a broker or agent to make a “buy to cover” order or use their direct trading rights.

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