What Does It Mean to Cover in Stocks?

“Covering” in the context of stocks refers to an investor’s action to close out a specific market position. This process involves fulfilling an obligation that arose from an initial sale of shares the investor did not own, thereby neutralizing market exposure.

Understanding Short Selling

Short selling is an investment strategy where an individual sells securities that they have borrowed. The primary goal of this strategy is to profit from an anticipated decline in the stock’s price. An investor borrows shares from a broker, who typically holds them in a margin account for another client, and then sells those borrowed shares on the open market.

After selling the borrowed shares, the short seller hopes the stock’s price will fall. If the price drops, the short seller can then buy back the same number of shares at a lower price. These repurchased shares are then returned to the lender, completing the transaction. This process allows the short seller to profit from the difference between the higher selling price and the lower buying price, minus any associated fees or interest.

This strategy involves risks, as there is no theoretical limit to how high a stock’s price can rise. If the stock’s price increases, the short seller faces significant, potentially unlimited, losses. Short sellers are also obligated to pay any dividends declared on the borrowed shares. Brokerage firms typically charge a borrowing fee, often expressed as an annualized interest rate, on the value of the borrowed shares.

The Action of Covering a Short Position

The act of “covering” a short position involves purchasing the exact number of shares that were initially borrowed and sold. This buy transaction serves to close out the open short position, effectively ending the investor’s obligation to the lender. When a short seller decides to cover, they place a “buy to cover” order with their brokerage.

Once the buy order is executed, the newly purchased shares are immediately used to return the borrowed shares to the brokerage firm, which then returns them to the original owner. The profit or loss from the short sale is determined by calculating the difference between the price at which the shares were initially sold and the price at which they were bought back. Any commissions, borrowing fees, and dividend payments made during the holding period are also factored into the final profit or loss calculation.

For instance, if shares were sold short at $50 and later bought back at $40 to cover, the gross profit would be $10 per share before expenses. This action removes the short seller’s market exposure and frees up margin capital. Covering a short position is the final step to complete the short selling cycle.

Why Investors Cover

Investors cover their short positions for several primary reasons. The most straightforward reason is to realize a profit when the stock’s price has declined as anticipated. By buying back the shares at a lower price than they were sold, the investor locks in the gain from the short trade.

Another common reason to cover is to limit potential losses when the stock’s price moves adversely. Since short selling carries the risk of unlimited losses if the stock price continues to climb, covering the position prevents further financial detriment. This action is a form of risk management, cutting losses before they become unmanageable.

A short seller might also be compelled to cover due to a margin call. A margin call occurs when the value of the shorted stock increases significantly, causing the equity in the investor’s margin account to fall below the brokerage’s required maintenance margin. To meet the margin call, the investor must either deposit additional funds or securities, or close out some or all of their short positions by covering them, thereby reducing the margin requirement.

Furthermore, a stock recall can necessitate covering a short position. A stock recall happens when the original owner of the borrowed shares decides they want their shares back, perhaps to sell them, vote in a corporate action, or for other reasons. In such cases, the brokerage firm will issue a recall notice, requiring the short seller to buy back the shares and return them within a specified timeframe.