To make good money trading stocks you must equip yourself with the right information. Buy to cover is an important concept in stock trading which makes it worthy of discussion.
Profit could still be made from a stock losing its value by short selling that stock. Short selling simply means acquiring shares from a broker and selling them on the open market. Shares acquired from the broker to short sell are borrowed.
If you buy a stock, selling the stock implies that you are closing the buy position. In the case of a short position, it is quite different and difficult because to enter a short sale you borrow shares from your broker which must be returned.
Contents
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- What is Buy to Cover?
- What is a Short Sale
- How to Close a Short Position
- Buy to Cover Vs Short Covering
- Buy Vs Buy to Cover
- What is Buy to Open and Buy to Close
- The Importance of Buy to Cover in Day Trading
- Interrelationship Between Stop Limit and a Buy to Cover Order
- How Long Do Short Sellers Have to Cover?
- How to know when you are Short Covering
- How to Identify a Short Covering Rally in Stock
- Real Life Example of Buy to Cover
- Conclusion
- FAQs
What is Buy to Cover?
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Buy to cover is a trade order instructing a broker to purchase enough shares of the borrowed stock intended to close out the investor’s short position. Technically, investors buy shares to cover short positions, and the order is initiated through their brokers.
Buying to cover and buying a stock are completely different concepts. A standard buy order is used by investors to buy and hold a stock which explains the concept of buying a stock. For buy to cover, the order is intended to close an existing short position. Also, at the end of the transaction, the stock bought is not owned by the investor because shares used were borrowed and must be returned.
If an investor short sell a stock, a buy to cover order could be initiated. The order is expected to exploit the opportunities that come with stock price dips by determining a particular price at which the buy to cover order would become active.
Practically, the order works such that, when an investor short sells a stock at a market price of $100, and a buy to cover order with an $80 limit guarantees that the investor makes a profit of $20 per share provided that the stock price dips below $80.
Contrary to an investor buying a stock which implies that future returns are made when the stock is trading at a price higher than the entry price and profit is made on short trade when stock is trading below the entry price. However, investors operating with a buy to cover order are making profits or losses from short selling a stock.
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What is a Short Sale
A short sale is a trading position that accrues gains when a stock value is declining.
In a short sale, the investor borrows stocks from a broker. Afterward, the stock is sold and profit made is put into their account. This opens a short sale position and remains open until borrowed shares are refunded.
It is referred to as a short sale because the order is initiated by selling stocks that you do not own.
How to Close a Short Position
Buy to cover is the market order used for closing short sales. That is, an investor buys the same amount of shares that was initially borrowed. The order implies that the investor has purchased shares to cover the borrowed shares.
Shares bought by investors are then returned to the broker that loaned them the stock originally. This act closes out the short sale position.
In a situation whereby, the stock loses its value while the short position is active, the trader makes profits from the situation. Furthermore, an investor would borrow the shares and then sells them. When the price is much lesser than the price it costs originally, the investor buys them back.
However, if the value of the stock had been bullish when the short position was active, then the short position would not make profits rather lose money. The investor would borrow the stocks and sell them, however, it would cost more money to buy the stocks back.
Buy to Cover Vs Short Covering
Short covering is also a day trading terminology used for exiting a short position and returning borrowed shares to one’s broker.
The act of short covering is also the same as buy to cover as they both mean closing out a short position.
Buy Vs Buy to Cover
Buying a stock is simply put as “buy low and sell high ” which is the basic of trading and a well-known trading concept. The buy order works such that, if you intend to be bullish on a stock, you input the number of shares and price which you want to buy and then initiate the order.
On the other hand, buying to cover is different from simply buying. For buy to cover, you are not buying but exiting a short position. Because the shares used to initiate the order are borrowed to cover up for a short sale position.
Therefore, shares earned from buy to cover trade are returned to the broker who originally borrowed the investor the shares.
What is Buy to Open and Buy to Close
Buy to open simply means opening a position by buying shares. While buy to close means buying to close a sell position.
So, in a short sale, you first make a sell and then buy to close out a position.
The Importance of Buy to Cover in Day Trading
Investors commonly buy qualified securities at a lower price like stocks intending to hold them for a long time and make profits in the process.
Short selling is not as common as buying and holding for long. Also, traders do not st sell stock and hold them for long. Most short positions are held possibly for a couple of days or weeks. A short seller regularly buys to cover intraday.
Assessing the past performance of major stocks over time, you would agree that the market is usually in a bullish trend. A bearish market is usually a short-time movement. Hence, it is not a strategy that should be deployed on a long-term basis. The golden rule is to follow the market trend.
When a stock turns out to be intensely shorted and demanded more, the borrowing costs increase. Interest charges incurred can begin to creep into expected profit.
Interrelationship Between Stop Limit and a Buy to Cover Order
Stop limit can also be used to close out short positions the same as long positions.
The order would be a stop limit order and you input the limit price at which you want to initiate a buy to cover as a buy limit order. When the price is set off, your order turns into a limit order at the imputed price and should be executed provided that there are sellers to fill your order.
How Long Do Short Sellers Have to Cover?
There is no time limit set for how long a short seller can hold short positions.
How long you hold a position depends on how much interest you are willing to pay to hold a position. Also, the interest rate can increase as borrowing pressure increases.
A short squeeze can be triggered if a stock is massively shorted and releases good news or fundamentals. If sellers fail to buy to cover their positions, brokers would start buying them in.
This is because short selling can potentially result in a direct or consequential loss. An investor can lose more than the capital available in a trading account. Hence, if losses are too much the broker closes all positions and you would be left liquidated.
Based on investment advisability conditions like this makes short selling unfriendly for new traders and also an unadvisable trading strategy for traders with poor trading psychology. It is expected that you shy away from short sales if you struggle with cutting losses.
How to know when you are Short Covering
A short cover can only occur when there is an active short position. A buy order initiated without a short sale is simply a buy order to purchase a stock.
For instance, if you are on a sell position of 200 shares and you activate a buy to order of 300 shares mistakenly, you would close your sell position of 200 shares and possess another 100 shares in a buy position.
Therefore, your short position has to be in place before short covering can take place.
How to Identify a Short Covering Rally in Stock
Short coverings are identified when the stock price has a sharp spike in the market and it can happen without any fundamental news.
A squeeze can be a rapid bullish move and could be a gradual climb where each dip is bought up.
You would see series of green prints on the time and sales as shorts hit the ask just to close out of their positions. When a stock is making new highs, buyers would be trying to buy in as well.
Real Life Example of Buy to Cover
Let us create an imaginary real life example of buy to cover and short sales. The example is divided into positive and negative samples;
A Profitable Short Sale Example
For instance, if Kingsley intends to open a short sale position in shares of XYZ the scenario would pan out as thus;
- Kingsley acquires a refundable XYZ share of 1,000 worth from his broker.
- The shares are then sold on the open market at $20 per share generating a profit of $20,000
- If the value of XYZ shares drops to $15 per share and Kingsley acquires 1,000 shares of XYZ at a lower price for a sum of $15,000. At this point, Kingsley is buying the shares to cover his position.
- If Kingsley returns 1,000 shares of XYZ to his broker, then it means he has sold shares for an amount greater than it cost him and makes a whopping profit of $5,000 on the whole transaction.
An Unprofitable Short Sale Example
- Kingsley acquires a refundable XYZ share of 1,000 worth from his broker.
- The shares are then sold on the open market at $20 per share generating a profit of $20,000
- If the value of XYZ shares rises to $25 per share and Kingsley acquires 1,000 shares of XYZ for a total sum of $25,000. In this situation, Kingsley is buying shares to cover his position.
- Kingsley must have made a sum of $20,000 off his original sale of which it cost more than that amount to buy back the shares to cover his position. On this transaction, Kingsley has lost a sum of $5,000.
Also Read: Head and Shoulders Pattern
Conclusion
Traders use the buy to cover order to exit short position trades which is a very risky trade.
Both new traders and experienced traders should consider demo trading to test their strategies before committing funds into short selling and make appropriate investment research on a stock and movements of the stock’s price in the past.
FAQs
Q1. Why do short sellers have to cover?
When a stock starts trading at a higher price, sellers are compelled to buy it back and close out their sell positions and book its losses.
Q2. Is there a Time Limit on Short Selling?
There is no stipulated time frame for holding a short position.
Q3. How Do You Cover a Short Position?
A short position is covered by initiating a buy order. A buy order is used to close out a short position because short selling implies shorting a share at a higher price and then buying the shares back at a lower price.
