What is a Buy To Cover
A buy to hedge is a buy order made on a security or other listed security to close an existing short position. A short sale is selling shares of a business that an investor does not own, because the shares can be borrowed but must be paid back at some point.
Basics of purchasing to cover
A purchase to cover a purchase order for a number of shares equal to that borrowed “covers” the short sale and allows the shares to be returned to the original lender, generally the investor’s own broker / broker, who may have had to borrow the stock at a third party.
A short seller bets on a drop in the share price and seeks to buy back the shares at a price lower than the original short sale price. The short seller must follow each margin call and redeem the shares to be returned.
Specifically, when the security begins to exceed the price at which the shares were sold short, the short seller’s broker may require the seller to execute a buy-hedge order as part of a margin call. To prevent this from happening, the short seller must always keep enough purchasing power in his brokerage account to complete the necessary “buy to hedge” transactions before the stock market price triggers a margin call.
Buy to cover and margin trades
Investors can trade in cash when buying and selling stocks, which means they can buy cash in their own brokerage accounts and sell what they have already purchased. Investors can also buy and sell on margin with funds and securities borrowed from their brokers. So a short sale is inherently a margin trade, because investors are selling something they don’t already have.
Margin trading is more risky for investors than using cash or their own securities due to the potential losses from margin calls. Investors receive margin calls when the market value of the underlying security moves relative to the positions they have taken in margin trading, namely the fall in securities values when buying on margin and the increase in securities values during the short sale. Investors must respond to margin calls by depositing additional cash or by making relevant buy or sell transactions to offset any unfavorable change in the value of the underlying securities.
When an investor sells short and the market value of the underlying security exceeds the short sale price, the proceeds from the previous short sale would be less than what is necessary to redeem it. This would result in a loss of position for the investor. If the market value of the security continues to rise, the investor will have to pay more and more to redeem the security. If the investor does not expect the security to fall below the original short sale price in the short term, he should consider covering the short position as soon as possible.
Key points to remember
- Buy orders to cover are orders issued by traders for a particular security to cover their short positions in it.
- Purchases to cover orders are generally margin transactions; therefore, investors and traders should ensure that their trading accounts have sufficient balances to cover margin calls.
Sample purchase to cover orders
Suppose a trader opens a short position in ABC stock. She is betting that the price of ABC, which is currently trading at $ 100, will drop in the coming months as the company’s finances are in poor shape. To benefit from her thesis, she borrows 100 ABC shares from a broker and resells them on the open market at the current price of $ 100. Subsequently, ABC shares fall to $ 90 and the trader places a purchase order to cover ABC shares at the new price and return the 100 shares it has borrowed from the broker. She must place the purchase to cover the order before a margin call. The transaction brings him a profit of $ 1,000 ($ 10,000 (purchase price) – $ 9,000 (sale price)).