What Is Buy to Cover & How Does It Work?
Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
Buy to cover refers to when an investor purchases a stock or other security to close out a short position.
A short sale is when a trader borrows shares, betting the price will drop. A buy to cover order is a way to “cover” the short positions, so they can be returned to the lender.
Taking a short position requires a margin account, and buy to cover helps to prevent a margin call (when the broker requires that funds be deposited in the margin account).
Key Points
• Buy to cover involves purchasing shares to close a short position.
• Taking a short position requires a margin account, because the shares are borrowed, with the expectation the price will drop, and the shares can be bought at the lower price.
• A short sale strategy aims to profit from the difference between the higher selling price and the lower buying price.
• If the stock price rises, a margin call may occur, requiring additional funds or liquidation. A buy to cover order “covers” the shares needed to close out the short position.
Buy to Cover Meaning
Traditionally, you buy a stock with a bullish outlook, and sell to close out your position. In an ideal situation, you buy low and sell high, securing the difference between the purchase price and the sale price as your profit.
What Is a Short Position?
A short position is different. If you think a stock is currently overpriced, you might sell the stock before you have actually purchased it, via a short sale. Within the world of options trading, this requires temporarily borrowing the shares, usually from your broker or dealer.
Then, once the stock (hopefully) goes down, you purchase the shares at the lower price and return them to the lenderclosing out your position and pocketing the difference between the higher and lower price.
Buying to cover is the after-the-fact purchase of shares that you previously shorted, to cover the trade and avoid a margin call. When you do a short sale by selling first, you will eventually need to repay your short sale by purchasing shares.
What Is a Buy to Cover Limit?
When placing a buy to cover order, there are two ways that you can close your position. The first is a market order, in which you simply close the position at the first available market price.
The other method involves using a buy to cover limit order, in which you set a maximum price at which you’re willing to purchase the share.
One advantage of the latter approach is that you know exactly the price that you’ll get for your shares. This can help you when planning your overall strategy. A drawback, however, is that if the market moves against you, your order may not get filled.
How Does Buy to Cover Work?
A buy to cover order works much in the same way as a traditional buy order. The main difference is the order in which you make your buy and sell transactions.
In a traditional buy order, you purchase shares that you intend to later sell. With a buy to cover order, you’re buying shares to cover a sale that you previously made.
Also, a traditional buy order can be executed using cash; a short sale requires a margin account.
Example of a Buy to Cover Stock
Here’s a buy to cover stock example to help illustrate how the process works:
• You believe that stock ABC is overpriced at $50.
• You sell short 100 shares of ABC, borrowing $5,000 on margin from your broker.
• After a few days, stock ABC’s price has dropped to $45.
• You issue a buy to cover order for 100 shares of ABC, paying $4,500.
• Your profit is $500 — the difference between the amount you receive from the short sale and the amount you pay to close the position, less any fees.
Sell Short vs Buy to Cover
“Selling short” and “buying to cover” are complementary actions within a short-selling strategy. If you think that a particular stock or investment is likely to go down in price, you can use a short sale to first sell shares that you’ve borrowed on margin, generally from your broker or dealer.
When you’re ready to close out your short sale transaction, you can place a buy- o cover order. This will purchase the shares that you sold originally, either at the market price or with a buy to cover limit order at a particular price.
If the stock declines in price as you expected, this strategy may yield a profit from selling high and then buying low.
Buy to Cover and Margin Trades
Using a buy to cover order is intricately tied in with both short selling and margin trading. When you sell short, you are using margin trading to borrow shares to sell that you don’t yet own.
When you are ready to close out your position, you issue a buy-to-cover order, purchasing the shares you need to correspond to the shares that you earlier sold on margin. If the stock price rises instead of falling, you may face a margin call, requiring additional funds or the liquidation of your position.
The Takeaway
A buy to cover is a purchase order executed to close out a short sale position in options trading. In a traditional sale, you purchase a stock first and then later sell the shares. When you sell short, you place a buy-to-cover order to close your position.
While investors are not able to sell options on SoFi’s options trading platform at this time, they can buy call and put options to try to benefit from stock movements or manage risk.
Investors who are ready to try their hand at options trading despite the risks involved, might consider checking out SoFi’s options trading platform offered through SoFi Securities, LLC. The platform’s user-friendly design allows investors to buy put and call options through the mobile app or web platform, and get important metrics like breakeven percentage, maximum profit/loss, and more with the click of a button.
Plus, SoFi offers educational resources — including a step-by-step in-app guide — to help you learn more about options trading. Trading options involves high-risk strategies, and should be undertaken by experienced investors. Currently, investors can not sell options on SoFi Active Invest®.
Photo credit: iStock/Ridofranz
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
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