What Is Buy to Cover?
"Buy to cover" is a term used in the financial markets to describe a specific type of trade order executed by investors to close out an existing short position. Short selling can be a complex strategy, often requiring a deep understanding of market movements and careful timing. Essentially, short selling involves selling shares that the investor does not own, which are borrowed from a broker. The objective is to profit from a decline in the stock price, allowing the investor to buy back the shares at a lower cost to return to the lender.
Key Takeaways
- Closure of Short Position: Buy to cover is a buy trade order that closes a trader’s short position.
- Borrowing Shares: Short positions are created by borrowing shares from a broker and a buy to cover transaction allows these positions to be "covered" by buying back the shares.
- Profit from Price Decline: Investors engage in short selling with the belief that a stock's price will decline. They sell shares at a higher price and aim to buy back at a lower price.
- Margin Trades: Buy to cover orders are generally executed as margin trades, which can involve significant risk.
How Buy to Cover Works
When an investor sells shares short, they are essentially betting that the stock's market price will decrease post-sale. They sell the borrowed shares at the initial selling price with the intention of repurchasing them later at a lower price. The difference between these two prices represents the profit (or loss) on the transaction.
Upon deciding to close their short position, the investor must execute a buy to cover order for the same number of shares that they initially borrowed. This order effectively "covers" their short position, allowing the investor to return the borrowed shares to the broker—typically, the same broker from whom the shares were borrowed.
The Risks of Short Selling and Buy to Cover Orders
Short selling and subsequently executing a buy to cover has inherent risks due to the dynamics of margin trading. Margin trading allows investors to borrow funds to increase their trading power, but it also amplifies potential losses.
- Margin Calls: If the price of the shorted stock rises instead of falls, the broker may issue a margin call, requiring the investor to deposit additional funds or execute a buy to cover order to cover potential losses.
- Unlimited Loss Potential: While the profit from a short sale is theoretically capped (the stock can't go below zero), the loss potential is unlimited since a stock's price can, in theory, rise indefinitely.
- Liquidity Risk: If many investors simultaneously decide to cover their shorts, it can create liquidity problems, leading to rapid price increases as demand outpaces supply.
Example of Buy to Cover
Consider an investor, Sarah, who believes that the stock of company XYZ is overvalued at $100 per share due to weak earnings reports. To capitalize on this belief, Sarah decides to sell short 100 shares of XYZ. After borrowing the shares from her broker, she sells them at the current market price:
- Initial Sale Price: $100
- Total Sale Proceeds: $10,000 (100 shares x $100)
A few weeks later, the stock price decreases to $90, aligning with Sarah's expectations. To close her short position, she executes a buy to cover order for 100 shares at this new price:
- Buy to Cover Price: $90
- Total Buy Back Cost: $9,000 (100 shares x $90)
- Profit from Transaction: $1,000 ($10,000 - $9,000)
By successfully executing the buy to cover order, Sarah profits from her initial short sale, effectively closing out her position.
Conclusion
The buy to cover strategy is a vital tool for short sellers, allowing them to conclude their trades and realize profits or limit losses. While it can be an effective method for capitalizing on stock price declines, it is also fraught with risks, including margin calls and the potential for catastrophic losses if the market moves against the investor. Understanding these dynamics is crucial for anyone considering engaging in short selling and utilizing buy to cover orders. As always, investors should conduct thorough research and consider consulting with financial advisors before participating in these high-risk strategies.