In the context of forex trading, to “cover” often refers to the act of closing out an open position to realize a profit or loss.
This is the equivalent of “selling” in the stock market but can be applied to both long and short positions in forex because you’re always dealing with two currencies at once.
- Covering a Long Position: If a trader has bought a currency pair, anticipating that the base currency will appreciate against the quote currency, covering this long position would mean selling that currency pair. The goal is that the base currency has appreciated, and by selling it back at a higher price, the trader can make a profit.
- Covering a Short Position: If a trader has sold a currency pair, anticipating that the base currency will depreciate against the quote currency, covering this short position would mean buying back that currency pair. The goal is that the base currency has depreciated, and by buying it back at a lower price, the trader can make a profit.
Remember that the forex market always involves buying one currency and selling another, so when you decide to close out or cover your position, you are essentially doing the reverse of your initial action.
Stock Trading
In stock trading, the term “cover” typically refers to the act of closing a short position.
When a trader is short a security, they have borrowed the security (often from a broker) to sell it, betting that the price will fall so they can later buy it back at a lower price for a profit.
To “cover” the short position means to buy back the security that was sold short, returning the borrowed shares to their original owner (often the broker).
If the security was indeed bought back at a lower price than it was sold, the short-seller makes a profit. If the price rose, however, the short-seller incurs a loss.
The process of covering a short position is significant because it can contribute to upward pressure on a stock’s price.
This is especially the case during a “short squeeze,” a scenario in which a stock’s price increases significantly, forcing short sellers to cover their positions to limit their losses.
As they buy to cover their short positions, it can drive the price of the stock up even further.
It’s important to note that short-selling carries significant risk. If a stock’s price rises instead of falls, the potential loss is theoretically infinite, as a stock’s price can rise indefinitely.
Short-sellers should carefully monitor their positions and have strategies in place to manage risk.