What Is Buy to Cover?
Buy to cover is a trading strategies term that refers to the act of purchasing shares of a security in the open market to close out an existing short position. When an investor takes a short position, they sell borrowed shares of a stock, anticipating that its price will decline. If the price does fall, the investor can then "buy to cover" those shares at the lower price, return them to the broker from whom they were borrowed, and realize a profit from the difference.
History and Origin
The concept of "buy to cover" is intrinsically linked to the practice of short selling, which is believed to have originated in 1609 with Dutch merchant Isaac Le Maire and his dealings with the Dutch East India Company. Le Maire reportedly sold shares he did not own, betting on their decline, thus necessitating a later purchase to settle his obligation.4 Historically, short selling, and by extension the action of buying to cover, faced scrutiny and regulatory responses, particularly after significant market downturns like the 1929 stock market crash. Regulations such as the uptick rule and subsequent rules by the Securities and Exchange Commission (SEC) were introduced to govern short selling practices and ensure orderly markets, making the act of buying back shares to close a short position a fundamental component of these transactions.
Key Takeaways
- Buy to cover is the action of purchasing shares to close out a short position.
- It is undertaken by investors who initially sold borrowed shares, anticipating a price drop.
- The goal is to repurchase shares at a lower price than the initial selling price to generate a profit.
- Failure to buy to cover, or doing so at a higher price, results in a financial loss.
- The timing of a buy to cover decision is crucial for managing the risks associated with short selling.
Formula and Calculation
While "buy to cover" itself isn't a formula, the profit or loss from a short sale, which is realized upon buying to cover, can be calculated.
The formula for calculating the profit or loss on a short sale is:
- Initial Selling Price per Share: The price at which the borrowed shares were originally sold.
- Buy-to-Cover Price per Share: The price at which the shares are repurchased to close the short position.
- Number of Shares: The total quantity of shares involved in the transaction.
- Commissions and Fees: Any charges incurred from the broker for the initial sale, the buy to cover transaction, and any stock loan fees.
A positive result indicates a profit, while a negative result indicates a loss.
Interpreting Buy to Cover
The act of buying to cover signifies a short seller's decision to close their bearish bet on a stock. This action can be driven by various factors, including the stock price moving favorably (downward), the price moving unfavorably (upward, triggering losses or margin calls), or a change in the investor's outlook on the security. A high volume of buy to cover orders can indicate a potential short squeeze, where a rapid increase in price forces short sellers to buy back shares quickly, further accelerating the price rise. Conversely, a steady pattern of buy to cover at declining prices suggests short sellers are successfully taking profits from their positions. Understanding the context of buy to cover activity requires observing overall market sentiment and the specific equity's price action.
Hypothetical Example
Consider an investor who believes that Company XYZ, currently trading at $100 per share, is overvalued and expects its price to fall. The investor decides to open a short position by borrowing 100 shares of Company XYZ through their margin account and immediately selling them for $10,000.
After a few weeks, Company XYZ announces disappointing earnings, and its share price drops to $80. The investor's prediction was accurate, and they decide to close their short position. They place a market order to buy 100 shares of Company XYZ at $80 per share, costing them $8,000.
Upon buying to cover, they return the 100 shares to the broker. Their initial sale generated $10,000, and buying to cover cost $8,000. Excluding commissions and fees, the investor realizes a profit of $2,000 ($10,000 - $8,000).
However, if Company XYZ's price had risen to $120 instead, and the investor chose to buy to cover at that price, it would cost them $12,000. This would result in a $2,000 loss ($10,000 - $12,000), not including commissions and borrowing fees.
Practical Applications
Buy to cover is a critical component of short selling and appears across various facets of capital markets and analysis. For traders, actively managing when to buy to cover is essential for risk management and locking in gains or limiting losses. For instance, a trader might set a limit order to automatically buy to cover if the price drops to a certain level, or a stop-loss order if it rises unexpectedly.
From a market analysis perspective, data on short interest and the volume of buy to cover activity can provide insights into market sentiment. High short interest, combined with rapid price increases, can signal a potential short squeeze, a phenomenon famously observed in January 2021 with the video game retailer GameStop, where a surge in its stock price forced many short sellers to buy to cover their positions, further accelerating the rally.3 Regulators also monitor buy to cover activity and short selling to ensure market integrity and prevent manipulative practices, as evidenced by rules like the SEC's new Form SHO filing requirements for institutional investment managers with significant short positions.2
Limitations and Criticisms
While short selling and the subsequent buy to cover action serve important roles in price discovery and market efficiency, the strategy has inherent limitations and faces criticisms. The primary risk of a short position, unlike a long position, is theoretically unlimited loss potential. If the price of a shorted stock rises indefinitely, the cost to buy to cover can far exceed the initial sale proceeds, leading to substantial losses. This risk is particularly pronounced during a short squeeze, where a rapid, unexpected surge in price forces short sellers to cover their positions at escalating costs.
Critics also argue that aggressive short selling can sometimes contribute to downward price momentum, potentially exacerbating market declines or targeting companies unfairly. However, academic research often suggests that short selling contributes positively to market efficiency by bringing negative information into prices and correcting overvaluations.1 Nonetheless, the emotional and financial pressures associated with managing a short position and the decision of when to buy to cover can be significant, especially in volatile market conditions.
Buy to Cover vs. Short Selling
The terms "buy to cover" and "short selling" are often discussed together but refer to distinct, sequential actions in a trading strategy. Short selling is the opening act of a short position, where an investor borrows shares and sells them in the open market, anticipating a price decline. It is the initiation of a bearish bet. Conversely, buy to cover is the closing act of that same short position. It involves repurchasing those shares to return them to the lender, thereby settling the obligation created by the initial short selling. One cannot exist without the other in the context of a short position; short selling creates the need, and buy to cover fulfills it.
FAQs
Why do investors buy to cover?
Investors buy to cover primarily to close out a short position and realize a profit if the stock price has fallen, or to limit potential losses if the stock price has risen. It's the essential step to unwind a short bet.
Is buying to cover always profitable?
No, buying to cover is not always profitable. If the price at which the investor buys back the shares is higher than the price at which they initially sold them, the investor will incur a loss.
What happens if I don't buy to cover a short position?
If you don't buy to cover a short position, you remain obligated to the lender for the borrowed shares. This means you continue to incur borrowing fees, are liable for any dividends paid on the shares, and face unlimited potential losses if the stock price continues to rise. Your broker may also issue a margin call, requiring you to deposit additional funds, or forcibly buy to cover your position if you cannot meet the margin account requirements.
Can buying to cover impact stock prices?
Yes, a large volume of buy to cover orders can significantly impact stock prices, especially if many short sellers are forced to cover their positions simultaneously. This can lead to a "short squeeze," where rapid buying activity drives the stock price up sharply.
What is the opposite of buying to cover?
The direct opposite of buying to cover, in the context of closing a position, is "selling to close," which is done to exit a long position (shares you own) and realize a profit or loss. In the context of opening a position, the opposite of short selling (which necessitates buying to cover) is buying shares with the expectation they will rise (going long).