What Is a Buy to Cover?

A “buy to cover” is a transaction in the financial markets used primarily within the context of short selling.

Short selling is the practice of selling securities that the seller doesn’t currently own, with the expectation that their price will decrease in the future and allow them to be bought back at a lower price.

The buy to cover order is executed to close or cover an open short position.

Essentially, it involves purchasing the equivalent number of shares that were initially sold short, in order to return them to the lender.

As such, the buy to cover closes out the position and realizes a profit or loss from the trade.

Key Takeaways – Buy to Cover

• Reversing a Short Position
  • “Buy to cover” is a trading action where a trader purchases securities to close an existing short position.
• Limiting Losses
  • It’s used to limit or realize losses if the market moves against the short position.
• Market Impact
  • Executing a buy-to-cover order can contribute to upward pressure on the security’s price.
  • Common in a “short squeeze” scenario where many traders are covering short positions simultaneously.

Trading Strategies Associated with Buy to Cover

Short Selling with a Target Exit Strategy

Traders may enter a short sale with a predefined price target at which they aim to buy back the shares to cover the position.

This strategy involves setting realistic exit points to maximize gains or minimize losses.

Stop-Loss Orders to Limit Losses

Incorporating stop-loss orders in short selling is a risk management strategy where a buy to cover order is placed at a predetermined price level that’s higher than the short-sale price.

This limits the potential loss if the market moves against the trader’s expectation.

Pairs Trading

Involves taking simultaneous long and short positions in two highly correlated securities (e.g., Ford and GM, gold and gold miners).

The strategy is market-neutral.

When the correlation between the two securities temporarily weakens, the trader shorts the outperformer and goes long on the underperformer.

Eventually, the trader uses buy to cover orders on the short position as part of the strategy to close the trades (ideally when the original/expected correlation resumes).

Hedging

Traders and investors might use short sales as a hedge against potential downturns in related trades/positions/investments.

Buy to cover orders are used to close these positions once the hedging purpose is served or when the market conditions change in a way that reduces the risk being hedged against.

Mean Reversion Strategies

This involves short selling a security that is believed to be overvalued by the market, with the expectation that its price will return to its mean or intrinsic value.

Buy to cover orders are executed to close the positions once the price reverts to its mean or a predetermined value indicating a sufficient profit margin.

Short Squeezes and Momentum Trading

Traders might short sell a stock anticipating a downturn but have to be vigilant about potential short squeezes – a rapid increase in the stock price, often driven by excessive short interest.

A well-timed buy to cover can limit losses in such scenarios.

Conversely, some traders use the momentum of a short squeeze to enter short positions, looking to cover when the irrationality of it all dies out and the price starts to normalize.

Summary

Each of these strategies will require a sophisticated understanding of markets and their dynamics, risk management, and the specific mechanisms of short selling and covering positions.

Traders use technical and fundamental analysis, market sentiment indicators, and sometimes algorithmic trading systems to make decisions on when to execute buy to cover orders.

FAQs – What Is a Buy to Cover?

What is the purpose of a “buy to cover” order?

The primary purpose of a “buy to cover” order is to close an open short position in the market.

It involves purchasing the same number of shares that were initially sold short.

This allows the trader to return the borrowed shares to the lender, effectively closing the position.

How does a “buy to cover” transaction affect a trader’s profit or loss?

A “buy to cover” transaction can affect a trader’s profit or loss depending on the price at which the shares are bought back compared to the price at which they were initially shorted.

If the shares are bought back at a lower price, the trader realizes a profit equal to the difference, minus any fees or interest.

Conversely, if the shares are bought back at a higher price, the trader incurs a loss.

Is a “buy to cover” order only used in bearish markets?

While “buy to cover” orders are often associated with bearish strategies, their use isn’t limited to bearish markets.

They’re a mechanism to close short positions, regardless of the market’s overall direction.

For instance, in pairs trading or hedging strategies, “buy to cover” orders are used as part of broader, market-neutral strategies or risk management practices.

How does a stop-loss order work in conjunction with a “buy to cover” order?

In the context of short selling, a stop-loss order is placed to automatically execute a “buy to cover” order at a specified price limit to prevent further losses if the market moves against the trader’s position.

This helps in managing risk by setting a predefined point at which the trader is willing to accept a loss and close the position to prevent larger potential losses.

What are the risks associated with using “buy to cover” orders in short selling?

The risks include:

• potential for unlimited losses if the price of the shorted asset increases instead of decreasing (famous examples include GameStop and AMC)
• the risk of a short squeeze (where prices rise rapidly due to high short interest), and
• liquidity risk (difficulty in buying back shares to cover the short position)

Additionally, the cost of borrowing shares to short can also impact the profitability of short selling strategies.