Buy to Cover — concise explainer
Definition
– Buy to cover: a buy order placed to close an existing short position by repurchasing the same number of shares that were borrowed and sold short.
– Short sale: selling shares you do not own by borrowing them (typically from your broker) with the obligation to return the shares later.
– Margin: borrowing money or securities from a broker to trade; short sales are executed on margin.
– Margin call: a broker’s demand for extra cash or securities when the equity in a margin account falls below required levels.
How it works (step-by-step)
1. Open short position: you borrow N shares from your broker and sell them immediately at the market (or limit) price, receiving proceeds into your margin account.
2. Monitor the position: because the trade is on margin, the broker tracks your account equity relative to maintenance requirements.
3. Decide when to close: to exit the short you place a buy to cover order for N shares. Those shares are used to return the borrowed shares.
4. Settlement and return: when the buy fills, the shares are delivered back to the lender and the short position is closed. Any net difference between sale proceeds and repurchase cost is your profit or loss (ignoring fees, interest, and dividends).
Why traders use buy to cover
– To realize gains if the stock falls below the short-sale price.
– To limit losses when the stock rises or when a margin call is imminent.
– To satisfy a broker request to return borrowed shares (for example, if the lender recalls their loaned shares).
Risks and margin mechanics (key points)
– Shorting has theoretically unlimited downside because a stock’s price can rise without limit; this makes buy to cover potentially very costly.
– Brokers require a minimum amount of equity (maintenance margin). If losses reduce equity below that level, the broker issues a margin call that may require an immediate buy to cover.
– To avoid forced liquidations, keep adequate buying power (cash or margin capacity) or use predefined stop orders to limit risk.
– Borrow availability can change; a broker may recall shares, forcing a buy to cover even if your thesis is still intact.
Checklist before and during a short trade
Before shorting:
– Confirm shares are available to borrow and note borrow fees.
– Calculate required initial and maintenance margin.
– Set a clear risk limit (stop-loss level or maximum loss you will accept).
– Factor in dividend obligations (you must pay ordinary dividends to the lender).
While short:
– Monitor price relative to your stop-loss, margin ratio, and account buying power.
– Track borrow cost and any lender recall notices.
– Be prepared to place a buy to cover if a margin call or recall occurs.
Worked numeric example (simple)
– You short 100 shares of ABC at $100 per share.
– Proceeds from sale: 100 × $100 = $10,000.
– Stock falls to $90. You place a buy to cover for 100 shares at $90.
– Cost to repurchase: 100 × $90 = $9,000.
– Gross result before fees and interest: $10,000 − $9,000 = $1,000 profit.
Counter-example showing risk
– If ABC instead rises to $120 and you are forced to buy to cover:
– Cost to repurchase: 100 × $120 = $12,000.
– Gross loss: $10,000 − $12,000 = −$2,000.
Assumptions and simplifications in these examples
– Ignore commissions, borrow fees, margin interest, taxes, and dividends. Real-world results will differ when those items are included.
Practical tips
– Maintain sufficient cash or margin capacity to meet potential margin calls.
– Use risk controls (stop orders, position-sizing) and check borrow availability/fees before initiating a short.
– Consider alternatives to naked shorting (e.g., put options) if you want limited downside risk.
Reputable resources
– Investopedia — Buy to Cover: https://www.investopedia.com/terms/b/buytocover.asp
– U.S. Securities and Exchange Commission (Investor.gov) — Short Selling: https://www.investor.gov/introduction-investing/investing-basics/glossary/short-selling
– FINRA — Short Selling and Regulation SHO: https://www.finra.org/rules-guidance/key-topics/short-selling
– NYSE — Short Sales and Borrowing Shares: https://www.nyse.com/markets/hours-calendars
Educational disclaimer
This explainer is for educational purposes only and does not constitute individualized investment advice or a recommendation to buy, sell, or short any security. Always consult your broker or a licensed financial professional about your specific situation before trading on margin.