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The phrase “buying to cover” describes the final step in an investment tactic, known as short selling, that seeks to profit from a bearish market. Investors who believe a security or index is going to decline can turn a profit – provided their analysis of the security or index is correct – by selling borrowed securities, typically stocks. Returning the borrowed securities requires the investor to buy them, which is known as buying to cover. There are other types of investment strategies that seek to profit from a declining market, but a short sale and buying to cover is one of the simplest. It is not, however, without risk. Here’s what you need to know about this tactic.

What Is a Short Sale?

A short sale is a position that gains money when the investment loses value. You can take short positions with many different investments, although for ease of use this article will refer to stocks.

In a short sale, the investor borrows stocks from another investor (typically a broker). They sell the stocks and put the resulting money in their account. This opens the short position. The position then stays open until you return the shares you borrowed.

It is called a short sale because you open it by selling stocks which you don’t yet own.

How Do You Close a Short Sale?

To close a short sale position, an investor buys the same number of shares that were originally borrowed. This is called “buying to cover,” since the investor has bought shares to cover the ones originally borrowed.

The investor then gives these shares to the third party that lent them the original stocks. This closes out the short position.

If the stock has lost value while the short position was open, then the trader will make a profit: The investor will borrow the shares and sell them, then will buy them back for less than they originally cost. If the stock has gained value while the short position was open, then the short position will lose money: The investor will borrow the stocks and sell them, but it will cost more money to buy the stocks back.

Buying to Cover Example

"BEAR MARKET AHEAD" signRichard wants to take a short sale position in shares of ABC Corp. A profitable short sale would look like this:

  • Richard borrows 1,000 shares of ABC Corp. from his broker.
  • He sells these shares on the open market for $20 per share, which gains him $20,000.
  • The price of ABC Corp. then declines to $15 per share.
  • Richard buys 1,000 shares of ABC Corp. at the lower price, for a total of $15,000. Here, he is buying shares to cover his position.
  • He returns the 1,000 shares of ABC Corp. to his broker.
  • Richard sold the shares for more than it cost him to buy them back, and makes $5,000 off the entire transaction.

An unprofitable short sale would look like this:

  • Richard borrows 1,000 shares of ABC Corp. from his broker.
  • He sells these shares on the open market for $20 per share, which gains him $20,000.
  • The price of ABC Corp. then increases to $25 per share.
  • Richard buys 1,000 shares of ABC Corp., which costs him a total of $25,000. Here, he is buying shares to cover his position.
  • He returns the shares of ABC Corp. to his broker.
  • While Richard made $20,000 off his initial sale, it cost him more than that to buy back the shares to cover his position. He loses $5,000 off the entire transaction.

The Risks of Buying to Cover

Businessman analyzes stock chartShort sales play several valuable roles in the market. The most common use of a short position is for investors who want to cover their portfolio in case of loss. Taking a well-calculated short position can help investors manage risk. For example, an investor may buy shares of individual tech companies but short the industry as a whole, creating a profitable investment in case something drags down their entire basket of assets. (Although the cost of this risk mitigation is that their short position loses money when their primary investments profit.)

However, it’s important to understand that trading a short position has a very different risk profile than a long position (in which you buy stocks and profit off their increased value). In a long position your risk is limited by the purchase price of the stock. You can never lose more than your initial investment. You make your purchase, then wait to see what you get back in gains.

In a short position your risk is not determined. Because you have no up-front costs beyond broker fees, you don’t stake any money. Instead the stock’s price determines your losses after the fact. This means that an unprofitable trade will lead you to actively lose money when you have to buy back the stock to close out your position. Moreover, there is no way of knowing how much money you will lose. The stock price can climb indefinitely, theoretically creating unlimited losses.

The Bottom Line

Buying to cover, also known as short covering, is when a trader buys stocks to cover the ones that were borrowed when opening a short position. It is how you close out a short position, and it results in a profit if the stocks have lost value while the position was open. Risk in a short position comes in both a different degree and kind from risk in a long position.

Tips for Investing

  • A financial advisor can help you use options and other tactics to manage risk in your portfolio. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool can match you with up to three local financial advisors, and you can choose the one who is best for you. If you’re ready, get started now.
  • Another tactic to use in a bear market is buying put options. Like short selling it is risky, but it also can produce big results. Whether you’re short selling or buying put options, make sure you pay attention to taxes when you invest in the stock market. SmartAsset’s capital gains tax calculator shows how taxes impact your gains.

Photo credit: ©iStock.com/monsitj, ©iStock.com/bauhaus1000, ©iStock.com/primeimages

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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