Covering Your Position

Covering Your Position (also known as 'buying to cover') is the act of closing out a short position. To understand covering, you first need to grasp short selling. This is a strategy where an investor borrows shares of a stock they don't own and immediately sells them on the open market. The hope is that the stock's price will fall. If it does, the investor can buy the shares back at the new, lower price and return them to the lender (this buying-back part is the “covering”). The profit is the difference between the initial selling price and the lower repurchase price, minus any borrowing fees. For example, if you short-sell a share at $100 and later cover your position by buying it back at $70, you've made a $30 profit. However, this strategy carries significant risk. If the stock price rises instead of falls, you must still buy the shares back to return them to the lender, but now at a higher price, resulting in a loss. Covering a position is therefore the final, crucial step that determines whether a short sale results in a profit or a loss.

An investor's decision to cover a short position is typically driven by one of two opposing outcomes: success or failure.

This is the best-case scenario for a short seller. You've made your bet that a stock was overvalued, and the market has agreed with you. The stock price has fallen, and you decide it's time to lock in your gains.

• Example: Imagine you believe company “Gadgets Galore” is wildly overpriced at $50 per share. You borrow and short-sell 100 shares, receiving $5,000. A few weeks later, after a disappointing earnings report, the stock tumbles to $30. You decide to cover your position by buying 100 shares for $3,000. You return the shares to the lender and walk away with a profit of $2,000 ($5,000 - $3,000), less any borrowing costs.

This is the painful reality when a short sale goes wrong. Instead of falling, the stock price rises. Since you must eventually buy the shares back to return them, every dollar the price increases is another dollar of potential loss. Unlike buying a stock (where your maximum loss is your initial investment), the potential loss on a short position is theoretically infinite because there's no ceiling on how high a stock price can go. Covering the position is an act of damage control—stopping the financial bleeding before it gets worse.

Short selling is done on credit in a brokerage account, using what's known as margin. This margin acts as collateral for your loan of the shares. If the stock price rises significantly, the value of your collateral might fall below the broker's required minimum. When this happens, the broker issues a margin call, demanding that you either deposit more cash into your account or sell other assets to meet the requirement. If you can't or don't comply, the broker has the right to forcibly cover your position for you—buying back the shares at the current high price to protect themselves. This often happens at the worst possible moment for the investor, crystallizing a substantial loss.

Most legendary value investors, including Warren Buffett, steer clear of short selling. The practice runs counter to the core philosophy of value investing for several key reasons:

• Asymmetrical Risk: Value investing is built on the concept of margin of safety—buying assets for less than their intrinsic value to protect against downside risk. Short selling turns this on its head. Your maximum possible gain is 100% (if the stock goes to zero), but your potential loss is unlimited. This is a poor risk-reward proposition.
• Market vs. Business Focus: Value investors focus on the long-term fundamentals of a business. Short sellers are often betting on short-term price movements, market sentiment, or negative catalysts. It's a game of timing the market, which is notoriously difficult.
• The “Short Squeeze” Nightmare: A major risk for short sellers is the short squeeze. This occurs when a heavily shorted stock starts to rise. The initial price increase forces some short sellers to cover their positions by buying shares. This buying pressure drives the stock price even higher, forcing more short sellers to cover, creating a vicious cycle of skyrocketing prices and catastrophic losses for those betting against the stock.

While some contrarian investors have made fortunes by identifying fraudulent or terminally flawed companies and shorting their stock (as famously depicted in the story of “The Big Short” with credit default swap (CDS)s against mortgage-backed securities), it remains an exceptionally difficult and high-risk strategy. For the average investor, focusing on buying wonderful companies at fair prices is a much more reliable path to long-term wealth.