How does a short seller "cover" a short?

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BlackTom AI · Accepted Answer

Question restatement: How does a short seller "cover" a short?

Option A: Pay the margin call. While paying a margin call may be part of maintaining a margin account, it is not the specific mechanism by which a short is covered. A margin call can occur if equity falls below required levels, but covering involves buying back the stock itself, not simply depositing funds to meet margin requirements.

Option B: Borrow stock through a broker. This describes the initial step of initiating a short, not the action taken to close or cover the short. You borrow shares to open a short position, but covering is about returning those borrowed shares.

Option C: Sell a stock and deposit the proceeds into a broker account. This describes initiating a sale or perhaps what you might do with proceeds, but it does not describe the act of closing a short position. Covering requires buying back, not selling more or placing proceeds elsewhere.

Option D: Buy the stock back and return it to the party from which it was borrowed. This precisely defines covering a short: you repurchase the same number of shares to return to the lender, thereby closing the position. It completes the cycle of a short sale by replacing the borrowed shares.

Option E: Initiate a margin loan against the short position. This is not how you cover a short. A margin loan is a financing mechanism for maintaining or supporting a position, not the action of closing it by returning borrowed shares.

Summary: The core concept of covering a short is to acquire the stock to return the borrowed shares, thus ending the obligation. The other options describe activities related to short selling or margin maintenance but do not constitute the act of covering. The correct operational step is to obtain the shares and return them to the lender, which aligns with option D.

How does a short seller "cover" a short?

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Assume you sell short 100 shares of common stock at $30 per share, with initial margin at 50%. What would be your rate of return if you repurchase the stock at $35 per share? The stock paid no dividends during the period, and assume no other transaction costs.

Shorting a stock, where you only make money if the stock goes down, has never been a successful investment strategy, based on the case studies we reviewed in class.

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