Buy to cover refers to when investors purchase shares in a stock that they had previously shorted. This is a form of margin trading that involves higher risk than more traditional buying and selling.
In this article, we’ll take a look at the buy to cover order, how it fits into short selling and margin trading, and when you might want to use a buy to cover order.
Buy to Cover Meaning
Traditionally, you buy a stock on which you have a bullish outlook, and sell to close out your position. In an ideal situation, you buy low and sell high, securing the difference between the purchase price and the sale price as your profit. If you think a stock is currently overpriced, you might sell the stock before you have actually purchased it, via a short sale. This requires temporarily borrowing the shares, usually from your broker or dealer. Then, once the stock (hopefully) goes down, you purchase the shares, closing out your position.
Buying to cover is that after-the-fact purchase of shares that you previously shorted. When you do a short sale by selling first, you will eventually need to repay your short sale by purchasing shares.
What Is a Buy to Cover Limit?
When placing a buy-to-cover order, there are two ways that you can close your position. The first is a market order, in which you simply close the position at the first available market price. The other method involves using a buy-to-cover limit order, in which you set a maximum price at which you’re willing to purchase the share.
One advantage of the latter approach is that you know exactly the price that you’ll get for your shares. This can help you when planning your overall strategy. A drawback, however, is that if the market moves against you, your order may not get filled.
How Does Buy to Cover Work?
A buy-to-cover order works much in the same way as a traditional buy order. The main difference is the order in which you make your buy and sell transactions. In a traditional buy order, you purchase shares that you intend to later sell. With a buy-to-cover order, you’re buying shares to cover a sale that you previously made.
Example of a Buy to Cover Stock
Here’s a buy to cover stock example to help illustrate how the process works:
• Let’s say that you think stock ABC is overpriced at $50.
• You sell short 100 shares of ABC, borrowing $5,000 on margin from your broker.
• After a few days, stock ABC’s price has dropped to $45.
• You issue a buy to cover order for 100 shares of ABC, paying $4,500.
• Your profit is $500 — the difference between the amount you receive from the short sale and the amount you pay to close the position.
Sell Short vs Buy to Cover
“Selling short” and “buying to cover” are two sides of the same transaction. If you think that a particular stock or investment is likely to go down in price, you can use a short sale to first sell shares that you’ve borrowed on margin, generally from your broker or dealer.
When you’re ready to close out your short sale transaction, you can place a buy-to-cover order. This will purchase the shares that you sold originally, either at the market price or with a buy-to-cover limit order at a particular price. If the stock has gone down in price as you expected, you will profit from selling high and then buying low.
Buy to Cover and Margin Trades
Using a buy to cover order is intricately tied in with both short selling and margin trading. When you sell short, you are using margin trading to borrow shares to sell that you don’t yet own.
When you are ready to close out your position, you issue a buy-to-cover order, purchasing the shares you need to correspond to the shares that you earlier sold on margin. Keep in mind that if the stock moves against you after your short sale (the stock’s price goes up instead of down), you face a margin call, in which your broker forces you to either liquidate your position or add extra money to cover your position.
The Takeaway
A buy to cover is a purchase order executed to close out a short sale position. In a traditional sale, you purchase a stock first and then later sell the shares. When you sell short, you place a buy-to-cover order to close your position.
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