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What Are Cover Orders And How To Use Them

26 Jul 2023

What are cover orders and how to use them?

Stock markets are known to provide substantial and faster returns compared to several other investment options. However, this investment comes with a fair amount of risks. Therefore, traders constantly seek strategies to mitigate these risks and maximise profits.

One such strategy is the use of cover orders. Let's learn more about cover orders and their various crucial aspects. 

What is a cover order?

A cover order is a type of market order that combines a primary order with a stop-loss order. It involves placing a buy or sell order and a predetermined stop-loss level. The stop-loss order is a protective mechanism to limit potential losses if the market moves against the trader's position.

By incorporating a stop-loss order, cover orders allow traders to define their risk tolerance and protect themselves from substantial losses.

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Types of cover orders

Cover orders can be categorised into the following types:

Short cover order

Short cover order is a market order where a trader sells a security that they do not own. The intention here is to buy it later at a lower price. A stop-loss order is simultaneously placed to limit potential losses. It provides risk management for short positions, protecting against unexpected price increases.

​​​​​​​Long cover order

Long cover order is a market order where traders buy a security while simultaneously placing a stop-loss order to limit potential losses. It provides a protective mechanism for long positions. Hence, allowing traders to define the risk tolerance and safeguard against adverse market movements.

How does cover order work?

Traders specify the trigger and limit prices while placing a cover order. The trigger price is the level at which the primary order is triggered. Whereas, the limit price is the price at which the primary order is executed. These specified stop-loss levels are linked to the primary order. They are triggered when the market price reaches the specified trigger price. Once the stop-loss order is triggered, it is executed as a market cover order.

For example, a trader wants to buy a stock with a cover order. They set a trigger price of Rs.100 and a limit price of Rs.105. If the market price reaches or exceeds Rs.100, the primary order is triggered, and the buy order is executed at or below Rs.105. If the market price falls below the stop-loss trigger price, the cover order is triggered, and the trader's position is automatically liquidated.

What are the advantages of cover orders?

Some of the benefits of cover orders are:

​​​​​​​Quick execution

Cover orders are executed swiftly, ensuring traders can take advantage of favourable stock market conditions immediately. The automatic triggering and execution of cover orders due to stop-loss levels enable fast response times.

​​​​​​​Precise entry and exit points

With cover orders, traders can define specific triggers and limit prices, allowing them to enter or exit positions at desired price levels. This precision helps implement trading strategies more effectively.

​​​​​​​Protection against market volatility

Cover orders protect against sudden market volatility by limiting the potential downside risk. In cover orders, traders can set stop-loss levels to safeguard their positions. This helps prevent significant losses during turbulent market conditions.

What are the challenges with cover orders?

Some of the drawbacks of cover orders are:

​​​​​​​Execution at market price

Sometimes, a cover order is triggered and executed at a market price different from the expected price. This execution slippage can lead to unexpected losses or reduced profits.

​​​​​​​Additional costs

Some brokers may charge additional fees or commissions for placing cover orders. Thus, it hampers the overall profitability of trades.

​​​​​​​Limited flexibility

Cover orders are designed to protect against downside risk. But they may limit the trader's flexibility in capitalising on potential gains. The predetermined stop-loss levels can result in exiting positions prematurely, missing out on further market upside.

The bottom line

Cover orders are a valuable tool in a trader's arsenal, balancing risk management and profit potential. However, it is crucial to understand cover orders to make a profitable decision properly. Cover orders can benefit you in manifolds when combined with thorough market analysis.

 

Related Articles: Understanding order types and margining in commodities | The way you execute your orders can make a vast difference | Understanding the nuances of smart order routing

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