The world of short selling can be a mysterious place. What are borrows? Locates? What are these extra fees?
Despite what your financial advisor may have told you, it’s possible to make money by going into debt — for a short time. You can sell shares you don’t own by short selling…
But you’d better exercise caution. Shorting stocks isn’t as easy as it may sound. And you’ll have to cover what you owe at some point.
That’s where buying to cover comes in. Whether you’re covering to secure a profit or covering your butt, I’ve got your back!
Here’s what you need to know about how to buy to cover.
Table of Contents
- 1 Buying to Cover: What Is Its Relationship With Short Selling?
- 2 What Does Buy to Cover Mean?
- 3 Understanding Buy to Cover: The Key Points
- 4 How Do You Place a Cover Order?
- 5 Examples of Buying to Cover
- 6 4 Tips for Short Selling Stocks
- 7 The Risks of Buying to Cover
- 8 Conclusion
Buying to Cover: What Is Its Relationship With Short Selling?
You’ve probably heard the phrase ‘buy low, sell high.’ Some people like to sell before they buy. When they do, that’s called a short sale.
Think of your trades like a coin. You’ve got two sides on a coin — heads and tails.
If you buy, you have to sell to close your position. And on the flip side of the coin, if you short sell, you have to buy to close your position.
What Is a Short Sale?
A short sale is when you borrow shares from your broker and sell them. It’s the opposite of going long. You sell before you buy.
Need more info on short selling? Check out this blog post.
Since you borrow the shares, you don’t actually own them. When you sell them, you take a negative position.
You also have to return the shares to your broker. To do so, you buy them. We call that buying to cover.
How Do You Cover a Short Position?
You buy back the shares through the same brokerage that loaned them to you. That covers the loan.
If you’re a skilled trader — or you’re lucky — you’re buying them back at a lower price. If you buy the shares for less than you sold them, you make a profit.
When you buy to cover, most brokers will automatically take back the shares. They also take their commission, locate fees (if applicable), and any due interest.
What Does Buy to Cover Mean?
Here’s some basic economics for you.
Whenever you buy something, you go into debt. We usually don’t think about it.
If you order a steak at a restaurant, you owe the restaurant. If you order a beer at a bar, you owe the bar.
Have you ever gone out with friends and they “cover” you?
We use the term “cover” in relation to our debts. Sometimes we do it without even thinking about it.
It’s the same with shorting stocks. Short selling is borrowing. When you buy the shares to return them to your broker, you’re covering the debt.
Cover means to protect or defend. Debt is a liability. When you buy to cover, you’re defending yourself against that liability. That’s why we use the term buy to cover.
Understanding Buy to Cover: The Key Points
A short sale means borrowing shares from your broker and selling them. It’s a negative position.
You buy to cover your debt, exiting your position. At the end of the trade, you have zero shares. And if all went well, you have a profit. Sounds easy, but shorting is definitely not easy. No trading is.
So what are some pros and cons?
Benefits of Buying to Cover
Hey, the great thing about any trade is the potential to profit, right?
You can’t take profits on your short sale without buying to cover. And you can’t stop out without buying.
Whether you’re taking profit or stopping out, you need to buy to cover. There’s a certain degree of relief that comes with closing a trade, whether on the winning or losing side.
There’s an element of tension that comes with being in a trade, whether it’s excitement or nervousness. Once you close your position, the weight is released. The uncertain becomes certain. You can move on.
Disadvantages of Buying to Cover
When you sell a stock, you’re increasing the supply. That has the potential to push a stock down. Not so bad for a short seller, right?
Buying to cover is indistinguishable from a normal buy order. If enough people are buying at once, that’s a surge in demand. That can eat into your profits. Or worse.
A short squeeze happens when several short sellers are all stopping out at the same time. They’re all trying to buy to close their positions. The surge in demand chases the price up.
Now, we retail traders are small fish in a big pond. I’ve never seen a market this volatile. That’s why my friend Timothy Sykes and I made this “Volatility Survival Guide.”
All of this volatility means that our position sizes probably won’t have a huge impact on the price of the stock. But if the crowd is moving in the same direction, the price can change fast.
Rapid changes in price can make it difficult to get the price that you want.
How Do You Place a Cover Order?
There are different ways to place a cover order depending on your broker and the platform you’re using.
Some platforms have only two options: buy and sell. Other platforms name options for short selling. Those are “sell short” and “buy to cover.” Or “short” and “cover.”
If you’re using StocksToTrade’s broker integration feature, you can place orders right from the platform. I think StocksToTrade is the best tool available for traders. You have access to beautiful charts, built-in scans, and so much more on one platform. Try it today for 14 days for only $7.
By the way, if you use StocksToTrade for placing your orders, you’ll use ‘Sell’ to sell short. And you’ll use ‘Buy’ to buy to cover.
What Is a Limit Price in a Cover Order?
When placing an order in the market, there are two basic types of orders — market and limit orders…
If you place a market order, it means you will get filled at the next available price. And a limit order allows you to set the price that you’re willing to accept.
What Is the Trigger Price in a Cover Order?
You can set certain conditions when you place an order. These are usually called “stop orders.”
You can stop-buy or stop-sell. A stop order doesn’t have to be a stop loss. There’s a distinction.
So let’s get into stop orders. This gets a little complex, so bear with me.
There are two parts to a stop order. First, you have the trigger price and the order placement.
When you set your stop order, you’re telling the system to do something. You’re saying, “if the stock hits this price, do this.” The trigger price means “if the stock hits this price.”
Now, there are two types of stop orders. There are stop limit orders and stop market orders.
If you use a stop market buy order, you’re saying, “if the price hits x, buy at any cost.”
When using a stop-limit buy order, you set the trigger price and the limit price. You’re saying that if the price reaches x, you’ll buy it for no more than y.
They can be the same price if you want. For example, you could set the trigger price and the limit price at $21.05.
How to Close a Short Sale
When you’re ready to close out your short sale, you buy the same amount of shares that you borrowed. Done.
Talk to your broker or practice on your platform to discover whether you can buy or if you need to buy to cover. As I said, some brokers only have a “buy” option. Others have a “buy to cover” option.
Examples of Buying to Cover
We’ve covered some theory, but what does this look like in practice? For me, it always helps to have a concrete, tangible explanation.
Say you short sell 1,000 shares for $1 per share. You owe your broker 1,000 shares.
So, you have –1,000 shares that you sold for $1,000.
Now the stock price drops. It’s trading at 50 cents. You buy 1,000 shares for $500.
This brings your position up to zero. You got $1,000 and you paid $500, so you have $500 left. Then your broker takes their cut. So your profit is whatever’s left after you pay your broker and any applicable fees.
4 Tips for Short Selling Stocks
Back in the day, I was a short seller. With this crazy bull market we’ve been having, I’ve switched sides. Remember, the trend is your friend.
That said, Michael “Huddie” Hudson is a short-biased trader and I dare say he’s legendary.
The cool thing about Huddie is he’s a mentor with the SteadyTrade Team. He gives a live webinar every week. Members of the SteadyTrade Team have access to every webinar in the archive. So you have an opportunity to learn from both me and Huddie.
And you can round that out with awesome trading psychology tips from Kim Ann Curtin. Talk about thorough market training.
Join the SteadyTrade Team today to take your trading to the next level. We’d love to have you!
Now, let’s get to some specific short-selling tips.
#1: Protect Your Capital
Risk management is crucial in any trading. As a beginning trader, your main goal should be to stay in the game. This is especially critical for short selling.
When you buy a stock (aka go long), the most you can lose is what you paid. But when you short a stock, your losses can be exponential.
- If you buy 100 shares of a $10 stock and it goes to $0, you lose $1,000.
- If you short 100 shares of a $10 stock and it goes to $30, you lose $2,000.
It might not sound very likely, but it happens more often than short sellers like. You could end up owing your broker a lot of money if you short the wrong stock at the wrong time.
#2: Always Have a Plan
Go into every trade with a plan whether you’re long or short biased.
Having a trading plan helps protect you. If you’re prepared for the worst, you can act while others are panicking. And if you’re prepared for the best, you can take advantage of the situation.
#3: Don’t Short Earnings Winners
When a stock beats on earnings, institutions and big investors might get interested. I know it’s exciting to see these stocks pop on up and give you a nice target … But believe me, trying to fight the big traders is just asking for trouble.
#4: Don’t Short Low Float Stocks
I know it’s tempting, but low float runners can fly. They set up with a lot of downside. More often than not, they’re moving because of a short squeeze.
Remember that float is the supply. The less supply there is, the more it will spike with demand. You don’t want to get caught in that.
Bonus Tip for Short Selling: Don’t Short Hot Sector Stocks
Remember, hot sectors are hot for a reason. Everyone’s interested in buying these hot sector stocks.
Even when a stock has a large float, if it’s in a hot sector, it can move big. Wait for sector momentum to cool down. Then you can potentially attack the overextended runners.
And as always, risk management is key.
The Risks of Buying to Cover
This is one of the hardest things about shorting: Your broker won’t always have shares to borrow.
It can be really frustrating when you see a big runner that you just know is bound to fail. You take a short position a little early, but maybe it keeps going. So you do the smart thing and cut your losses.
When the stock turns around again, you’re looking to sell short, but there aren’t shares available. You’ve given up your opportunity.
It happens to the best of us. One of the risks of buying to cover is that you’re giving up your position and you might not be able to get it back.
The best way to avoid this is to be selective about when you take your position. That’s why you must have a plan.
There you have it, folks.
Short selling means borrowing shares from your broker and selling them.
When you open a short trade, you’re taking a negative position. Remember, that means you’re going into debt.
Buying to cover means covering that debt and closing your position.
Too many uneducated traders make shorting sound easy, but the risks can be exponentially high.
Whether you’re cutting losses or taking profits, you’re trading against yourself.
Be safe and respect your stop losses. I hope to see you in the SteadyTrade Team chat room! Sign up today!
Where did you first hear the term ‘buy to cover’ and what did you think it meant? There’s nothing like a good origin story! Leave a comment below!