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The term “buy to cover” refers to placing a market order intended to close a short position, restoring borrowed shares used in a transaction to the lender. People must do this to complete the deal and can be compelled to do so as part of a margin call if a broker becomes concerned about an outstanding loan of shares. People can place a buy to cover order with a broker or representative, or exercise trading privileges directly to buy the necessary shares.
In a short position, someone is gambling on a tumble in price for a stock. The person makes an agreement to sell a set number of shares at the current value, without actually owning any shares. Instead, shares are borrowed, usually from a broker. Short traders are generally allowed to wait as long as they want to take advantage of the market and close the short position at the right time. When the investor buys to cover, shares are bought up at the new market price and given to the lender to take care of the loan.
People want to wait for the sweet spot, when a share's price has dropped and does not appear to be dropping any further, before they buy to cover. The goal is to pocket as much of the difference between two share prices as possible. The problem arises when a stock's value goes up instead of down. If the lender isn't anxious, the borrower may be able to wait it out and see if the share value drops. More commonly, a broker will issue a margin call, alerting the investor to the fact that she isn't holding enough funds in her brokerage account to keep it open, and that funds or securities need to be deposited, or the broker will start liquidating securities.
As part of a margin call, the broker can also specify that the investor must buy to cover. He needs to replace the shares borrowed for a short sale within a set period of time. There is a potential for taking a loss, as the investor may end up paying more for the new shares than the previous shares were sold for, and this difference will be covered out of pocket. A short sale gone wrong can represent a significant financial blow.
When someone issues an order to buy to cover, representatives usually try to get the best prices possible, looking at available options, with the goal of limiting the financial damage.
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