Buy to cover is an order type made against a stock with the purpose of closing an existing short position. Traders are required to place the buy order with a broker so as to fulfill the requirements of a margin call or to close a position for a profit.
Short selling is the process of borrowing shares from your broker to sell in the open market with hopes of buying them back at a cheaper price. By initiating a buy-to-cover order, the trader is able to cover the short sale allowing the shares to be returned to the rightful lender.
How It Works
To better explain how the buy-to-cover order works, we are going to use this example. Let’s assume we have Company X. As a trader, you have information that the company may be overvalued or its financial condition is deteriorating and as such, its stock price currently does not reflect the above elements. Thanks to your savvy trading experience, you are aware that the stock price of Company X will likely fall.
As a trader, you can take advantage of the above situation by simply making placing a short sell order on the stock. Since this is a short sale order, you will have to borrow the shares from your broker to sell in the market.
Once shares fall and you are up nicely on them you decide that it’s time to close your position by placing a buy to cover order. You can buy to cover with a limit or market order; both will allow you to exit the trade and realize your gains.
It is important to understand shorting requires you to use margin which can be very risky. This is because the potential of losses may occur as a result of broker margin calls. It is common for investors and traders to receive a margin call in the event the stock moves against your position.
What you need to know is that shorting a stock is very speculative and can result in large losses very quickly. The good news is that the same can also allow you to profit from a falling stock which allows you to play the market both ways.