What is a Cover Order? Meaning, Benefits, Types & How It Works
You have decided to trade positions in the stock market, but have you understood the basic concepts properly? Experienced traders know that they need to maintain a mandatory margin amount as prescribed by the stock markets to cover the losses incurred from the trade. This is a part of the risk mitigation. But what if you want to pay a lower margin and, as a result, increase the trade's leverage? Cover Order gains significance here. Let's understand what a cover order, its benefits, how it works, the different types, and the difference between it and a bracket order in this session is.
What is a Cover Order?
A Cover Order is a special purchase order with a risk reduction feature. It is a market or limit order that gives extra exposure combined with a stop-loss order, protecting the investor. The advantage is that once you place a stop-loss order, you know how much money you'll lose if the deal goes against you. However, the main things to be noted are:-
The system will concurrently place two orders:
• A market or limit order and
• A stop-loss market order will only be executed if the chosen stop loss trigger price is met. If the trigger price is hit, the stop-loss order is executed as a market order. A Cover Order is used when both of these orders are placed simultaneously. Cover Orders allow you to limit any potential losses on a trade.
You cannot cancel this stop-loss order because a cover order is either a market order or a limit order with a mandatory stop-loss order in a specified range.
The risk is automatically reduced because the stop-loss order is put simultaneously as the contract is entered.
Cover orders should be squared off the same day and are only used for intra-day positions. If not squared off by the trader, the system will initiate automatic squaring off.
The two main benefits are:
• Greater exposure
• Lower risk.
Greater exposure helps the traders utilize the margin benefits, and the stop-loss placement reduces the losses incurring from the trade. The significant advantage is that the trader can choose the loss he is willing to undergo and undertake disciplined trading. A risk mitigation facility helps the trader to trade care-free.
How Does Cover Order Work?
A cover order, as explained before, is a two-stepped concurrent order process. When the trader needs to buy/sell a share, he will have to place a stop-loss order along with it, and this stop loss should be reversed. Let's see how this is done.
Place an order as a market or Limit order according to your trade need. A market order is a price of the share available at the market at the point you choose to trade, and a limit order is the set pre-determined price of a share at which the trader decided to buy it.
If the share reaches a pre-defined daily limit, place the Stop-loss trigger point order, where a transaction is reversed.
Suppose Wipro is trading at Rs 560 and the daily pre-defined limit is 10%, the trader can place the stop loss between 504 and 616 depending upon his buy or sell as the trigger point. This stop loss can be modified. However, in such conditions, the margin will be recalculated. The downside is that if the first part of the trade is done, the trade cannot cancel the cover order, though he can exit the one-sided position. But you can cancel the cover order if the first part of the trade does not happen. However, if the stop loss isn't triggered, the positions will be automatically squared off.
Types of Cover Order
Depending upon a trader's trade needs, cover orders can be classified into two categories:
• Short Cover Order
• Long Cover Order
When you decide to sell an asset, the cover order you execute will be called Short Cover order. On the other hand, if you purchase a share, it is a long cover order. In the case of a short cover order, the investor tries to sell high and buy low. However, if the market condition changes, his stop loss will be executed, minimizing his losses. For example, if MrX is at Rs.1000/share, he might set his stop loss at Rs.1100/share. If the market price reaches the stop loss trigger point, the squaring is done.
The trader tries to buy low and sell high in the long cover order. For example, if he buys at Rs.1000/share, he might set a stop loss at Rs.900/share, and squaring is done once the market price meets the trigger point.
Illustration
I buy at Rs.100/share; I might place the stop loss at Rs.90 and the target price at Rs. 120 with a bracket order. If the stock plummets down, the stop loss might be executed and squaring off happens. However, on the other hand, if the stock price rise, the target price is executed, and the position is exited. In case of pending positions, it will be squared off by the system. In the case of both cover orders and bracket orders, if you use a limit order for initial trade, then stop loss and target price might not happen if the first limit order is not executed.
Conclusion
Both are useful in risk mitigation. But you will need greater practice to use them efficiently for quick intra-day trades.
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Frequently Asked Questions
1. What is a Cover Order in trading?
A Cover Order is an order structure that combines a primary buy or sell order with a mandatory stop-loss order. It is generally designed for intraday trading, subject to the broker and applicable market-segment rules.
2. What is the main purpose of a Cover Order?
The main purpose of a Cover Order is to help traders define a stop-loss level when entering an intraday position and manage potential downside risk.
3. How does a Cover Order work?
A Cover Order consists of a primary order and a compulsory stop-loss order. For a buy position, the stop-loss is generally placed as a sell order, while for a sell position, it is generally placed as a buy order.
4. What is the difference between a Cover Order and a regular order?
A regular order does not necessarily require a stop-loss, while a Cover Order includes a mandatory stop-loss as part of its structure.
5. Is a Cover Order an intraday order?
Cover Orders are generally intended for intraday trading. However, their availability and applicable rules can vary depending on the broker, exchange and trading segment.
6. Does a Cover Order have a mandatory stop-loss?
Yes. A mandatory stop-loss is one of the key features of a Cover Order. The exact stop-loss rules may vary by broker.
