Buy to Cover
What Is Buy from Cover's perspective?
Buy to cover alludes to a buy order made on a stock or other recorded security to close out an existing short position. A short sale includes selling shares of a company that an investor doesn't possess, as the shares are borrowed from a broker yet should be reimbursed sooner or later.
Understanding Buy to Cover
A buy to cover order of purchasing an equivalent number of shares to those borrowed, "covers" the short sale and permits the shares to be returned to the original lender, typically the investor's own broker-dealer, who might have needed to borrow the shares from a third party.
A short seller wagers on a stock price going down and looks 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 starts to rise over the price at which the shares were shorted, the short seller's broker might expect that the seller execute a buy to cover order as part of a margin call. To keep this from occurring, the short seller ought to continuously keep enough buying power in their brokerage account to make any required "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 while buying and selling stocks, meaning they can buy with cash in their own brokerage accounts and sell what they have recently bought. On the other hand, investors can buy and sell on margin with funds and securities borrowed from their brokers. Consequently, a short sale is intrinsically a margin trade, as investors are selling something they don't currently possess.
Trading on margin is more hazardous for investors than utilizing cash or their own securities in light of likely 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, specifically the decline of security values while buying on margin, and the rise of security values while selling short. Investors must fulfill margin calls by storing extra cash or making significant buy or sell trades to compensate for any unfavorable changes in the value of the underlying securities.
At the point when an investor is selling short and the market value of the underlying security has risen over the short-selling price, the proceeds from the prior short sale would be not as much as what is expected to buy it back. This would bring about a losing position for the investor. Assuming the market value of the security keeps on rising, the investor would need to pay progressively more to buy back the security. In the event that the investor doesn't anticipate that the security should fall below the original short-selling price in the close to term, they ought to consider covering the short position sooner than later.
Illustration of Buy to Cover
Assume a trader opens a short position in stock ABC. After their research, they accept ABC's stock price, which is trading at $100 currently, will fall before long in light of the fact that the company's financials are signaling that the company is in distress. To profit from 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.
In this way, ABC's stock falls to $90 and the trader places a buy to cover order to buy ABC's shares at the new price and return the 100 shares they borrowed back to the broker. The trader must place the buy to cover order before a margin call. The transaction nets the trader a profit of $1,000: $10,000 (sale price) - $9,000 (purchase price).
- Buy to cover alludes to a buy trade order that closes a trader's short position.
- The trade is made on the conviction that a stock's price will decline, so shares are sold at a higher price and afterward bought back at a lower price.
- Buy to cover orders are generally margin trades.
- Short positions are borrowed from a broker and a buy to cover permits the short positions to be "covered" and returned to the original lender.