A buy to cover option permits an individual to purchase securities to repay a broker he or she has borrowed shares from for a short position. When an investor borrows shares, they do not own them, and they must be given back to the broker at some point in the future. The investor wants the price to go down, so the shares can be purchased on the cheap and traded back to the broker at this less expensive price. However, if the price of the shares begins to raise, the broker may ask for immediate repayment. Therefore, the investor should always have the cash needed in order to buy the shares at the current price, effectively buying to cover the loss.

Call on Borrowed Shares

In a short sale situation, the investor borrows shares of a security and sells them at a high price. Borrowed shares must always be repaid to a broker. Typically, the investor will have the choice of when to repay the shares. This means the investor can wait as long as necessary to get the best possible price, repurchase the shares, and give them to the broker. The difference in prices is profit for the investor.

When the shares go up in value, the broker can immediately call for repayment. This is a form of calling the account, often termed a margin call, that requires the investor to repay borrowed sums. The investor must immediately rectify the situation by replacing the shares in the account.

Executing a Buy to Cover

In order to replace borrowed shares that have since been sold, an investor must buy back the shares. The problem is the shares have become more expensive. This means the investor will lose money by replacing the shares at the current price. Unfortunately, this is part of the risk of a short sale option, and the investor must be prepared to lose this money if a short sale does not go the way they planned.

To buy to cover, the investor will purchase the number of shares required by the broker at the current list price. The shares will be placed back into the brokerage account, effectively canceling the debt. The investor will lose money in an amount equal to the difference between the price he or she initially sold the shares for and the price they were repurchased with.

Preparing for a Buy to Cover 

To prepare for this event, an investor should always have enough money in a brokerage account to buy to cover any short position. Smart investors will track the price of a borrowed stock, watching to assure the shares could be repurchased at any point with the money in the account. If the shares climb so high as to make this impossible, the investor should either add more money to the account or sell and cut losses. Only the investor can make this decision, but they must do so knowing the broker could call in the shares at any point, and holding onto a pricey short position is a significant risk.

blog comments powered by Disqus