What is Cover Order?
When investors trade position in the stock market, they are required to pay a margin to the broker to ensure that risk involved with such trade is covered. The stock exchange also prescribes a minimum margin for trading position.
However, if investors wish to pay a lower margin and consequently, raise the leverage of such trade, they can choose a Cover Order (CO). It is a variant of a trading position in the stock exchange – Market Order or Limit Order – accompanied by a Stop Loss Order. This in-built risk minimisation mechanism allows traders as well as brokers to go for higher leverage when buying or selling assets such as Equity cash, Equity Futures & Options, Commodity F&O, etc. And because the risk associated with trading reduces, a cover order margin requirement is also low.
In essence, a Cover Order constitutes two components of trading – initiating position (Market or Limit Order) and a Stop Loss Order. The SL order is essential and thus, compulsory to a Cover Order. It is placed simultaneously with a buy or sell order and cannot be cancelled later.
It is imperative to note that all Cover Orders must be squared-off before 3:10 p.m. every day or else an automatic square-off mechanism is triggered. Hence, this method of trading position is explicitly used by intraday traders.
How Does a Cover Order Work?
A Cover Order can either be placed through a Market Order or a Limit Order.
- A Market Order is where an investor aims to enter into a trade at the best possible market price of an asset available at that time.
- A Limit Order is where a trader will only enter into a trading position if the desired price level or better is achieved. In other words, they will only purchase an asset at a predetermined price level or lower and sell an asset at the desired price level or higher.
This order to purchase or sell an asset is accompanied by placing a Stop-Loss Order. The latter is a function where a transaction shall be reversed if the price of an asset reaches a predetermined limit. For instance, if a stock is purchased at Rs. 100 and Stop-Loss price is set at Rs. 90; then shares will automatically be sold should its price reach Rs. 90. This risk-mitigating mechanism in Cover Order trading restricts the risk for an investor. This Stop-Loss Order can also be modified but cannot be cancelled.
Below mentioned are a few scenarios to understand the functioning of a Cover Order better.
Scenario 1: Market Order placed for the purchase of stocks and Stop-Loss activated
Mr Raj placed a Cover Order in the stock market at 11:15 a.m. to purchase 1000 stocks of Company A using Market Order mechanism. He purchased the shares at Rs. 200/share and set Stop-loss price at Rs. 180.50 for each share. At 1:10 p.m. prices of such stocks plummeted; at first, it fell to Rs. 195, and then by 1:50 p.m. it fell to Rs. 185.70. Furthermore, at 2:30 p.m. it reached Rs. 180.50. As the price reached the Stop-Loss level, those 1000 stocks were automatically sold. Thus, Mr Raj’s loss was limited to Rs. [1000 * (200 – 180.5)] or Rs. 19500.
The calculation mentioned above is summarised in a tabular form below.
|Number of shares purchased||1000|
|Stop-loss price||Rs. 180.5|
|Loss incurred when stop-loss was activated||Rs. 19500 [1000 * (200 – 180.5)]|
Scenario 2: Limit Order placed for the sale of stocks and Stop-Loss activated
Ms Komal placed a CO at 11:00 a.m. for sale of 10,000 stocks of Company B using the Limit Order mechanism. She set the limit to Rs. 150/share for sale. Simultaneously, she set the Stop-Loss limit at Rs. 165/share. All the shares were sold at 11:30 a.m. at Rs. 152/share. At 12:15 p.m. the share price stood at Rs. 155; at 1:20 p.m., the price was Rs. 158, at 1:35 p.m. it was Rs. 160, and at 2:30, it stood at 165. As the price reached Rs. 165/share, her position was squared-off.
Scenario 3: Market Order placed for a sale of stocks and Stop-Loss modified and activated
Ms Agarwal placed a CO through Market Order at 11:10 a.m. to sell 2000 shares of Company C. At that time, the best available price in the market was Rs. 100/share. Therefore, she set the Stop-loss price at Rs. 120/share. At 11:30 a.m. share prices started to rise and then stood at Rs. 102.5/share; at 11:50 a.m. share price was 106/share. At 12 p.m., she decided to change her Stop-Loss price to Rs. 110/share. At 12:37 p.m., the share price reached Rs. 110/share and her shares were subsequently squared-off. Thus, she was able to reduce her losses by modifying the Stop-Loss limit from Rs. 120/share to Rs. 110/share.
Types of Cover Order
Cover Orders are categorised based on whether an investor chooses to purchase an asset or sell it. These are –
- Short Cover Order
If an investor decides to sell the shares, of let’s say Hindustan Unilever, it is said that he/she is going short on Hindustan Unilever. Such a sale made through Cover Order is said to be Short Cover Order. Through going short, investors aim to sell their shares at a high price and purchase at a lower price.
Subsequently, Stop-Loss value is set above the price at which an asset is sold. For instance, if Mr A goes short on Company A at Rs. 100/share, then he might set the Stop-Loss value at Rs. 110/share. Hence, such stocks will automatically be squared-off should the share price reach Rs. 110.
- Long Cover Order
When an investor purchases the stocks of a company through Cover Order, it is said to be a Long Cover Order. Going long on, let’s say for Coal India, means that an investor is purchasing its shares at a lower price to sell it later at a higher price.
In the case of a Long Cover Order, investors set the Stop-Loss value below the purchase price of a stock. For example, if Ms A places a Long Cover Order on Coal India stocks at Rs. 100/share, then she might set the Stop-Loss value at Rs. 90/share.
Benefits of Cover Order
There are two primary benefits of Cover Order which set it apart from other Order options.
- Higher leverage
Investors enjoy higher leverage on the trading position through Cover Orders as it incorporates the mechanism of Stop-Loss Order. This mechanism significantly reduces the risk an investor incurs compared to normal order, and henceforth, fetches higher leverage. For instance, leverage on equity cash can be as high as 30 times the contract value.
- Low associated risk
When placing a Cover Order, the risk associated with trading position goes down dramatically. It is because of the Stop-Loss Order; wherein, the maximum loss a trader can incur from a transaction is known beforehand. Hence, it allows a trader to place a buy or sell order as per his/her risk appetite. Additionally, traders do not need to keep an eye on share prices consistently and minimise losses.
Drawbacks of Cover Order
A few drawbacks of Cover Order are –
- Traders cannot cancel the Stop-Loss Order, although it can be modified.
- With Cover Orders, traders cannot exit order before it is squared-off.
- An asset would be automatically squared-off if its prices do not trigger Stop-Loss, which might result in the realisation of lower capital gains.
These are a few setbacks which traders can face when they place Cover Orders. However, CO is widely opted for by intraday traders because it accounts for the asset price fluctuations in intraday trading by limiting the risk.