The stock market has traditionally been an incredibly effective way to invest, with the overall trend of the market being to increase in value over time. While there are sure to be runs and corrections, these are always short-term events that contribute to this overall rise in average values, producing opportunities for both buyers and sellers of particular stocks to make a profit from the movement. One of the most popular ways to sell stocks for those that can afford it is called short selling, but if the stock price rises for a stock you shorted, you may be forced to buy to cover.
When you buy to cover, you are placing an order to buy stocks to hedge losses on a short position. Since the shares used to sell short are generally not owned by the investor but borrowed from a broker, either the losses or the stock will need to be repaid.
Short selling a stock, as well as the buy to cover that may eventually be needed to close out those positions, can be extremely complicated. There is a significant amount of risk involved in selling stock that the investor does not own, and while there exists the possibility of incredible profit, there is the potential for devastating losses. We're going to take a close look at what it means to buy to cover, how to do it, as well as some tips for selling short without putting your investments in a bind.
What Is Short Selling?
Many investors in the stock market choose to take long positions, which means they buy stock and hold it for a relatively long period. The main objective here is to buy when the stock price is at its lowest potential price for the foreseeable future, allowing it to gain value over time and be sold at a later date and for a higher price, making the investor a profit. This can be looked at as placing a bet that the underlying asset, the stock, will go up in value so that it can be sold for more than was paid.
Short selling, on the other hand, is placing a bet that the price of the stock is going to go down soon. However, the short sale often occurs in such a way that the investor sells stock that they don't own, often owned by the investor's broker. Then when the price drops, the shares are bought at a lower price, locking in the profit from the sale and replacing the shares that were borrowed.
There are two very different risk levels involved in long and short positions, and while one can limit the investor's potential losses, the other cannot. Conversely, one has the potential for unlimited profits, while the other doesn't.
When an investor enters a long position, they buy the stock for a specified price which limits their loss to only that cost. If the price drops to zero, only the initial investment is lost, though the price could climb infinitely high, potentially making an infinite profit. When a short position is entered, the profits are limited to the maximum potential reduction in the price of the underlying asset. On the other hand, should an investor enter a short position and the price of the stock then rise, the investor is exposed to potentially infinite losses. This is what can lead to their need to buy to cover.
What Does Buy To Cover Mean?
The purpose of a buy-to-cover order is to cover short positions that may end up incurring a loss and to limit those potential losses. Buy to cover orders are sent to the investor's broker and are only used to buy the same number of shares that the investor sold short so that their short position can be closed out.
A buy-to-cover order differs from all other buy orders. In standard buy orders, the investor places a buy order, acquires the stock, and then owns and holds that stock. A buy-to-cover order is specifically created with the sole purpose of closing out a short position, and once the order is filled and complete, the investor has paid for the shares but does not own them themselves since the shares are replacing or returning shares borrowed on margin.
For example, an investor who short sells shares of fictional ticker ABCD when the price of the underlying is $80 may choose to create a buy-to-cover limit order for a share price of $75. This allows the investor to enter a short position at $80, and ensure they make a $5 profit for every share included in the buy-to-cover order. This not only gives them a $5 profit per share, should the price drop to $75 or below, but it also allows them to close their short position simultaneously.
Buy To Cover & Trading On Margin
When investors enter a position, whether long or short, they generally have two options for payment. One option is to pay with available cash from their brokerage account or sell previously held stocks using the proceeds. The other option is to trade with securities, assets, or funds which are subsequently borrowed from the brokerage. This is referred to as trading on margin.
Since an investor entering a short position, by definition, does not already own the underlying asset, all short selling is considered margin trading. Margin trading can be incredibly risky, both in general and particularly when concerning short selling, where the potential losses can be infinite.
When this potential for elevated losses presents a significant enough risk to the investor or even their brokerage, they can face a "margin call." A margin call happens when the value shifts more than a predefined amount, and the brokerage requires additional financial backing, such as additional deposits or liquidating other assets.
Is A Buy To Cover Order Risky?
The short answer is no; quite the contrary, a buy to close order serves to limit the risk and potential losses for a short position. Entering a short position is inherently risky, even when it aligns with your risk tolerance, and when the investor creates a buy-to-cover limit order, for example, it can serve as a safeguard against runaway losses.
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Tips For Short Sellers
Short selling can be risky, but it can also be incredibly useful for making a profit when the market turns bearish. Here are some tips for being as successful as possible when shorting.
Keep Your Capital Safe
Manage your risk accordingly, and do what you can to protect the capital you invest. Investors that go long on a stock only stand to lose what they paid, while shorts have the potential to lose much more.
Make it part of your overall investment plan to not only have your entry point strategized but your exit as well. Make sure you build your plan ahead of making any final investment commitments or decisions. Panic and the fear of missing out are unbelievably strong forces, so be sure you minimize their effect as much as possible.
Don't Short Stocks With Low Available Float
The stock float is the available supply, and when you short a stock with a short supply, you run the very real risk of being squeezed. A short squeeze can stick a short seller with unmanageable losses and has been the cause of ruining more than one investor's career.
Earnings Winners Are Short Seller Traps
If a company just had an earnings report that beat estimates, they are likely going to see some investor attention, which can mean your short goes sour fast.
Real-World Buy To Cover Examples
There have been two incredibly high-profile instances of large-scale buying to cover in the relatively recent past. Very recently, in 2021, the brick-and-mortar video game darling GameStop was heavily shorted, and many large hedge fund investors placed large short-selling bets against the store.
A Redditor publicized the short-selling information, as well as the incredibly low float for the ticker, subsequently buying thousands of shares. When other Redditors and retail investors jumped in as the stock rose in price, it drove the price even higher, resulting in all-time high strike prices. As the stock price skyrocketed, many large investment managers were forced to buy to cover their short positions, resulting in a "short squeeze" that cost some of the largest hedge funds billions.
Another famous example is the short squeeze that happened to investors who shorted Volkswagen stock in late 2008 when the amount of available stock was drying up quickly. This was partially due to Porsche buying up much of the available stock, at one point owning more than 30% of Volkswagen, which caused the price to spike nearly infinitely in October 2008 and made the automaker the most valuable company on the planet for a few days.
Understanding Buy To Cover
Selling stocks short, particularly short selling on margin, is not something that many investors choose to do, due in no small part to the level of risk involved. However, knowing how a buy-to-cover order works is essential to those that are considering entering the short-selling arena. There is the potential for robust profits when stock prices drop, but if things don't go as planned, being able to buy to cover can save your investments from financial oblivion.
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Shawn Manaher is a former financial advisor, has founded 5 online businesses, and is a coach, speaker, podcast host, and author. He's been featured on The Consults Corner on TAE Radio, The Writing Biz, What's Your Story, and more.