What is a 'Buy To Cover'

A buy-to-cover is a buy order made on a stock or other listed security to close out an existing short position. A short sale involves selling shares of a company that an investor does not own, as the shares can be borrowed but need to be repaid at some point. This buy order of purchasing an equal number of shares to those borrowed "covers" the short sale and allows the shares to be returned to the original lender, typically the investor's own broker/dealer, which may have to borrow the shares from a third party.

BREAKING DOWN 'Buy To Cover'

For the investor who has bet on a stock price going down, the hope is to be able to buy the shares back at a lower price than the original short sale execution price. The short investor must follow each margin call and repurchase the shares for returning. Specifically, when the stock begins to rise above the price at which the shares were shorted, the investor's broker may require that a buy-to-cover order be executed as part of a margin call. To prevent this from happening, the investor should always keep enough buying power in the brokerage account to make any needed "buy to cover" trade before the market price of the stock triggers a margin call.

Trade on Margin

Investors can make cash transactions when buying and selling stocks, meaning they can buy with cash in their own brokerage accounts and sell what they have previously bought. Alternatively, investors can buy and sell on margin with funds and securities borrowed from their brokers. Thus, a short sale is inherently a margin trade, as investors are selling something they do not already own, and must borrow it from their brokers.

Trading on margin is riskier for investors than using cash or their own securities, because of potential losses from getting broker margin calls. Investors receive margin calls when the market value of the underlying security is moving against the positions they have taken in margin trades, namely the declining of security values when buying on margin, and the rising of security values when selling short. Investors must satisfy margin calls by depositing additional cash or making relevant buy or sell trades to make up for any unfavorable changes in the value of the underlying securities.

Buy to Cover

Buy-to-cover is likely to occur when an investor is selling short and the market value of the underlying security has since risen above the short-selling price. Then, the proceeds from short selling the security earlier would be less than what is needed to buy back the same security, resulting in a losing position for the investor. If the market value of the security continues to rise, it would cost the investor increasingly more to buy back the security. Even without a margin call, the investor should consider whether to cover the short position sooner than later, when the belief is the security's market value may not fall below the original short-selling price any time soon.

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