As a short seller, you’re playing with house money. That is to say, you’re borrowing stocks to sell, with the hope that you can purchase them again in the future at a discount and return them to the lender. Regardless of what the stock trades for in the future, eventually you’ll need to buy to cover your borrowed shares.
Buying to cover is the practice of purchasing shares of a company that you’re short on, as a way to secure those shares for delivery when the time comes to close out your short position. You’ll need to return the same number of shares that you borrowed, which means buying that number at the current market rate. If it’s lower than what you sold the original shares for, you profit. If it’s higher, you lose money.
Every short sale begins with a borrow and ends with a buy to cover action. Here’s what investors need to know when it comes to returning borrowed shares.
An Example of Buy to Cover
To understand the buy to cover action, it’s important to get familiar with the entire process of short-selling. Here’s a quick example that illustrates the practice, including the buy to cover exit:
Marcel believes GoPro Inc. (NASDAQ: GPRO) is overvalued at its current share price of $10. He decides to open a short position. He borrows 100 shares from his broker to sell at $10, netting him $1,000. Then, over the course of a month, the price drops to $8. Marcel buys 100 shares at the current market rate of $8 ($800), to cover the 100 he borrowed. He returns the shares to his broker and keeps the net difference of $800.
In this situation, the short thesis was correct and buying to cover net the investor a profit. However, the inverse can also happen. If the price would’ve risen to $12, the buy to cover would’ve cost $1,200, resulting in a $200 loss for the investor.
Covering at a Gain vs. Covering at a Loss
When the time comes to cover the position, investors can either cover at a gain (profit) or cover at a loss, depending on whether the price of a security decreased or increased.
It’s important to keep an eye on open short positions, and to close those positions as market conditions change. For instance, you might exercise an option early if the price of a stock drops dramatically, to capitalize on a temporary pullback. Likewise, you might cover at a small loss as a way to safeguard against an unforeseen bullish price trend.
Remember, the purpose of buying to cover is to close the short position and return the borrowed shares to the lender. Whether this happens at a profit or a loss depends on the share price at the time the short option comes due or when you choose to exercise it.
Parties Involved in a Buy to Cover
Though it’s initiated by an investor, there are actually three parties involved in a buy to cover action. The investor is a middle-man, merely facilitating the exchange of shares and collecting the profit or covering the loss incurred in the transaction:
- The investor needs to buy and return shares originally borrowed for the short sale.
- A seller in the market needs to sell shares to the investor at the current market price.
- The broker lent shares to the investor and will receive an equal number back.
Outside of the investor, the two other parties control the variables that dictate the profitability of a buy to cover and the subsequent short sale. The seller of the securities dictates the sale price, while the broker dictates the number of shares the investor must return.
Buy to Cover a Margin Call
Short sales are inherently margin trades, because they involve selling something you don’t own. As a result, short sellers are subject to the rules of a margin account, which differ from broker to broker. And, because it’s your broker that you’ll borrow the shares from, it’s important to understand the significance of a buy to cover margin call.
Sometimes, a broker might force an investor to buy to cover a margin call. This usually happens when the current price of the stock rises above the value of the borrowed shares, which signals a net loss. Even though the short might not be due yet, brokers need to make sure investors can fulfill their obligation to repurchase and return shares. Forcing a buy to cover is a simple way for broker lenders to mitigate their risk.
Investors can often avoid a buy to cover margin call by funding the balance of their margin account well-above the difference in the price between borrowed and current share prices.
The Culmination of a Short Sale, Good or Bad
Short selling can be a risky yet lucrative way to profit in a falling market. Opening a short position involves selling borrowed shares with the hope that you’ll be able to buy them back cheaper in the future. When the time comes to buy to cover the short, the price per share you pay will ultimately dictate whether you cover at a gain or cover at a loss.
If you’re going to borrow shares to short, prepare to buy to cover. One way or another, you’ll need to give those shares back to their original owner, your broker.
