What Is Buy to Cover?

Buy to cover is an order placed for buying a security that will close a short position.

A short position is when an investor borrows a security from a broker such as shares to sell them at a high price and buy them back at a low price to make a profit. Because the securities such as shares are borrowed from a broker, they must be returned.

A close position in a short sale is when the trader buys back the shares to exit trading and return the borrowed shares. Traders hope to buy back shares at a lower price so they can benefit from the profit margin. In a short sale, the trader must buy back the shares to close the position because the borrowed securities are to be returned at a pre-agreed point in time.

For instance, let’s say an investor speculates that the price of XYZ company’s shares will plunge in the next one or two days. So, she borrows shares of XYZ company from a broker and sells them on the same day at $50. In the next two days, the price falls to $20, so she buys the shares back by placing a buy-to-cover order.

Investors buy securities such as shares to hold onto them to profit from appreciation in their price. A buy-to-cover order, in comparison to a regular buy order, is meant to close the short position. The short sales are profitable only if the price of shares falls in short term. It also means that the selling of shares when the price is too high will result in a loss to the trader.

Is Buy-to-Cover Risky?

Buy-to-cover is buying shares back to close a short position. The short position in trading is risky.

There are two approaches in stock trading: short and long trade. In long trade, the investor or trader buys stocks to benefit later from an increase in the price of the stock. So, even if the stock price falls to zero, the investor will lose 100% of their investment but they won’t do anything to anyone.

In short sales, the trader or investor borrows the shares from a broker to sell shares at a high price and then buys back shares at a lower price to benefit. But in short sales, there is extreme risk involved.

If the price of the share goes higher than what the trader had sold them for earlier, the trader has to suffer the loss. For instance, if a trader shorted shares for $50, and later the price reached $200, the trader will have to suffer a loss of $150 when buying to cover.

There is no limit on the maximum price that a stock can reach therefore the risk associated with short sales is extreme. Only experts who have immense experience in trading go for short sales with calculated risk.  

Buy-to-cover is necessary because the exact amount of shares that were originally borrowed from the borrower must be returned.

By the same measure, shorting a stock has limited upside potential since the lowest stock price is zero. The most profit you can earn from a $50 stock is $50, while a $50 stock you own directly can appreciate by much more than $50. A stock's upside is unlimited, but only if you own it directly.