What Is Buying to Cover and How Does It Work?

Buying to cover is a transaction in financial markets that concludes a specific investment strategy. It involves purchasing securities to close out a previously established position. This action is distinct from a regular buy order, which typically initiates an investment expecting price appreciation. Understanding this concept is essential for market participants to manage their exposures and finalize trading activities. This process ensures obligations are met and financial outcomes are realized.

Understanding Buying to Cover

Buying to cover relates to short selling. Short selling is an investment strategy where an investor borrows shares of a company and immediately sells them on the open market, anticipating that the stock’s price will decline. The goal is to buy back those shares at a lower price, return them to the lender, and profit from the difference between the selling and repurchase prices.

Buying to cover is necessary because the shares initially sold were borrowed, not owned. To close the short position and fulfill the obligation to the lender, the borrowed shares must be repurchased. This action of buying back and returning the shares is what “buying to cover” means. It is the final step that completes a short sale, allowing the investor to exit the trade.

An investor engages in short selling with the expectation of a price drop, aiming to profit from a bearish market. If the stock price indeed falls, the investor can acquire the shares at a reduced cost. Conversely, if the price rises, the investor still must buy back the shares, but at a higher price, resulting in a loss. This mechanism highlights why buying to cover is an important part of short selling.

The Mechanics of Buying to Cover

Executing a buy to cover involves placing an order through a brokerage account. When an investor decides to close a short position, they instruct their broker to purchase the necessary shares. This is done by selecting a “buy to cover” option on the trading platform, distinguishing it from a standard buy order for opening a long position.

A margin account is required, as short selling fundamentally involves borrowing securities. Once the order is placed, the brokerage executes the buy on the open market at the prevailing price, or at a specified price if a limit order is used. These purchased shares are then used by the broker to return the original borrowed shares to the lender.

Investors can choose different order types for buying to cover, such as a market order, which executes immediately at the current market price, or a limit order, which specifies a maximum price. A limit order provides control over the purchase price but does not guarantee execution if the market price does not reach the specified limit. This step formally closes the short position, ending the borrowing arrangement.

Implications for Short Sellers

Once a short seller executes a buy to cover, the short position is closed. This concludes the borrowing agreement with the broker, relieving the investor of the obligation to return the borrowed shares. Profit or loss from the short sale is realized, calculated by comparing the initial selling price of the borrowed shares to the price at which they were bought back.

Beyond profit or loss, buying to cover helps manage ongoing costs associated with short selling. Short sellers incur borrowing fees for the shares, charged as an annualized interest rate on the value of the borrowed shares and can fluctuate daily based on supply and demand. Additionally, short sellers are responsible for paying any dividends distributed on the borrowed stock during the period the position is open.

Buying to cover is essential for avoiding or addressing margin calls. A margin call occurs if the shorted stock’s value rises significantly, causing the investor’s account equity to fall below required maintenance levels. To satisfy a margin call, an investor must deposit additional funds or securities, or the broker may liquidate other positions in the account. Promptly buying to cover can prevent such situations, limiting potential losses and ending the accrual of borrowing costs and margin interest. Gains and losses from short sales are generally treated as capital gains or losses for tax purposes.