How to Cover a Short Position to Close Your Trade

When an investor anticipates a decline in a stock’s price, they may initiate a short position. This strategy involves selling shares that are not personally owned, but rather borrowed from a brokerage firm. The objective is to repurchase these shares at a lower price in the future, thereby profiting from the price difference.

Closing such a position requires “covering,” which means buying back the same number of shares that were initially borrowed and sold. This repurchase allows the investor to return the borrowed shares to the lender, fulfilling the obligation and finalizing the trade’s financial outcome.

Understanding What Covering a Short Position Entails

Covering a short position involves a two-step process: borrowing and then buying to return. An investor first borrows shares from their brokerage, and immediately sells them in the open market. This initial sale generates cash, which is held in the investor’s margin account.

The objective of covering is to repurchase an equal number of shares at a price lower than the initial selling price. These shares are then returned to the brokerage, closing the borrowed share obligation. The difference between the selling price and the repurchase price, minus any associated costs, represents the profit from the short trade.

Short positions are maintained within a margin account, which means the investor is using borrowed funds or securities. While there is no strict time limit for how long a short position can be held, the investor must continuously meet the margin requirements set by the brokerage. Brokerages also retain the right to recall shares at any time, which would necessitate immediate covering, regardless of the stock’s current price. Holding a short position also incurs interest charges on the borrowed shares, which accrue daily and impact the overall profitability of the trade.

Executing the Cover Order

To close a short position, an investor must place a “buy to cover” order with their brokerage. This informs the brokerage that the purchase is intended to fulfill the obligation of a previously shorted position, rather than to open a new long position.

Various order types can be employed when executing a buy to cover, depending on the investor’s strategy and market conditions.

A “market order” will execute immediately at the best available price in the market. While this ensures prompt execution, the final purchase price cannot be guaranteed, which can be a consideration in fast-moving markets.

Alternatively, a “limit order” allows the investor to specify a maximum price they are willing to pay for the shares. The order will only execute if the stock’s price falls to or below this specified limit. This provides control over the purchase price but carries the risk that the order may not be filled if the desired price is not met.

“Stop orders” offer tools for risk management if a shorted stock unexpectedly rises. A “stop-market order” instructs the brokerage to buy the shares at the prevailing market price once the stock reaches a predetermined stop price. A “stop-limit order” is similar, but once the stop price is triggered, it becomes a limit order, specifying a maximum purchase price and introducing the possibility of non-execution if the price moves too quickly beyond the limit.

Calculating Profit or Loss Upon Covering

Determining the financial outcome of a covered short position involves a calculation. The profit or loss is calculated by subtracting the buy-to-cover price from the initial sell price of the borrowed shares, then multiplying that difference by the number of shares traded. For example, if 100 shares were shorted at $50 each and later covered at $40 each, the gross profit would be ($50 – $40) x 100 shares = $1,000. Conversely, if those shares were covered at $60, the gross loss would be ($50 – $60) x 100 shares = -$1,000.

Brokerage commissions and fees impact the net profit or loss. While many online brokerages offer commission-free trading for U.S. stocks, some may charge a per-trade fee. Full-service brokers might charge a percentage of the transaction value. These charges reduce any gains or increase any losses from the trade.

From a tax perspective, gains and losses from short sales are treated as capital gains or losses. Internal Revenue Code Section 1233 provides rules for these transactions. Short-term capital gains are taxed at ordinary income tax rates. Capital losses can be used to offset capital gains, and if net losses remain, up to $3,000 can be deducted against other ordinary income annually, with any excess losses carried forward to future tax years.