Buy to cover is a common term in financial markets that is used to describe when a trader or investor covers its net short position. In this article we will go over the most common questions about buy to cover, to try to understand how it works.
What is buy to cover?
Buy to cover is used to describe a buying trade to cover a short position. When a stock is shorted, the position needs to be covered, and therefore the trader or investor needs to buy back the stock, or as it is commonly described buy to cover.
Shorting a stock requires essentially 2 distinct trades. One is when the shares are borrowed, and sold. The second one is when the same shares are bought. The buying trade is what is described as buy to cover.
How does buy to cover work?
When you short a stock you essentially borrow the shares and sell them on the open market. In order to complete the trade, you will need to buy the shares back, or what is also referred to as covering a short position.
The trade of buying back the shares can be described as short covering or buy to cover.
Buy to cover example
Let's consider an investor that decides to short 100 shares of stock XYZ, which is trading at $1. He receives $100 for shorting the stock. Although the stock might go up or down, the trader will have to cover its short position, which means buying back those shares. He then proceeds to buy to cover the short position.
Buy to cover vs buy
It is also important to understand the main differences between buying a stock and buying to cover a short position.
What's the difference between buy and buy to cover?
When you buy a stock, you hold it in your portfolio, and benefit from price appreciation or even dividends. However, when you buy to cover, you do not own the stock. You are simply buying back the shares you borrowed to cover your short.
The main difference between buy to cover vs buy is that buying implies an investor that is long certain security. This means that it will invest in it for a certain period of time, while a buy to cover is simply an investor or trader closing its short position by buying back the shares.
Can you buy to cover after hours?
Yes, although trading after hours presents a few challenges like lower liquidity and higher bid-ask spreads, it is possible to cover a short position after hours. As long as you are buying the same amount of shares you shorted, as long as the order gets filled, you can buy to cover after hours.
What happens if a short seller Cannot cover?
When a short seller cannot cover, its order will not be filled. This can happen for two main reasons:
- The short seller placed a limit order with a low bid
- There are no shares available to trade
The short seller placed a limit order with a low bid
If a seller placed a limit order below the price at which the stock is trading, the order cannot get filled. This can result in not being able to cover the short position. The only way to deal with this situation is by increasing the bid so that it is closer to the ask.
There are no shares available to trade
A short seller might not be able to close its short position because there are no shares being traded, and this could signal that it is an illiquid stock. This situation can put the short seller at risk because the stock price might go up, while not being able to cover the short position.
If the stock price goes up considerably there is a risk of a sizeable loss.
Buy to cover in options
Although buy to cover is a term that is applied to shorting stocks, there can be a misunderstanding with options because there is a similar expression used by options traders. When you sell an option, either a call or a put, you can buy back the same options. This is referred to as buy to close because you are buying the options contract to close the trade.
It is also important to be aware of the difference between these two terms, and also understand how buy to open is different from buy to close.
If you are thinking of shorting a stock, and you still do not understand all of these terms like short covering and buy to cover, it is important to spend some time understanding how shorting works.
You want to avoid shorting stocks without knowing how the process works because there are significant risks.