What is a Cover Order? - Definition, Components and More

What Does Cover Order Mean in Trading and Its Components?

A cover order is an intraday order which comes with an in-built risk control mechanism. This is because you place an entry trade and a stop-loss together. The entry order lets you buy or sell a security at the prevailing market price or a price you specify. The stop-loss defines the price at which you exit a trade if the prevailing market price of an asset moves against you.

Now, let us understand the aspects or components of this strategy, which include the following:

1. Intraday Trading 

Also known as day trading, this trading strategy allows you to purchase and sell securities or assets on the same trading day. 

For equity cash-market stocks, regular trading begins at 9:15 AM IST. Non-F&O stocks can be traded until 3:30 PM IST. Equity derivatives, including stock futures, trade from 9:15 AM to 3:40 PM IST.

2. Market Order 

It means placing a purchase or sell order of assets as per the prevailing market price. For example, let’s say a stock is trading at ₹500 right now. You placed a market order to buy 100 shares. The order gets executed at ₹500 per share.

3. Limit Order 

This is where you enter your buy or sell amount. Your order will execute when prices reach that level. Suppose you want to buy those shares at ₹490. You put a limit order at that price. If that stock price hits ₹490 or a better price, your order executes.

4. Stop-loss 

This order closes a trade automatically at a certain price level if the market moves against you, limiting your losses. Suppose in this trade, you set a stop loss at ₹490. If the stock falls to this price, your order triggers to exit your position.

What is the Working Process of a Cover Order?

A cover order works by executing your trader orders in two parts. As you have seen earlier, you may choose to trade as per the prevailing market price, or you may want to execute a trader order if you see an asset price hitting your desired price level or better. The other leg of this transaction is a stop loss to potentially square off a position with minimal losses.

As you have noted its components with an example, for each, let us take the essence from that understanding and explore another instance to get the full picture. Continuing with that one, suppose you are looking at that stock, currently trading at ₹500. Analysing the trend, you sense that its price may go up and you decide to opt for a cover order approach.

In this example, your primary market order revolves around buying 100 shares of that stock at the prevailing market price. You also set up a stop-loss at ₹490. It means that if prices drop below this point, your order will be executed automatically, saving you from drastic losses. 

Here, two different scenarios may appear, one of which is in your favour and another one against you:

1. The Favourable Scenario

Suppose during that trading session the share prices rise to ₹510. As you have set your primary order to execute at ₹500, it secures your purchase of 100 shares at the same price. Here, your stop-loss does not come into effect. As the price went up by ₹10 per share, you make a profit of ₹1000 (i.e. ₹10*100 shares). 

2. The Unfavourable Market Scenario

Suppose instead of that stock price going up, it starts going down. It plunges to ₹490 per share. Since you have set your stop-loss at the same amount, it leads to a sell order at that price. This strategic order placement reduces your potential loss to ₹10 per order. Without that stop-loss, if that price keeps going down further, you would incur a greater loss. 

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What are Some Types of Cover Orders?

The types of this intraday trading strategy depend on whether a trader wants to purchase (or take a long position) or wants to sell (or take a short position) an asset. Depending on their trade decision, there are two types of orders, i.e. a long and a short cover order. Here is a detailed description of the two:

1. Short Cover Order 

A Short cover order in the stock market is the strategy by a trader to take a short position or sell securities. While participating in day trading, traders sell a security and aim to purchase it back at a further lowered price. This way, they try to make a profit from that price difference. 

In case the price of a security does not drop, traders may reduce losses by buying back that asset at a higher price through a strategic stop loss placement. Suppose you decide to take a short-sell position of those 100 shares at ₹500 each and you place a stop loss at ₹510. If prices drop to ₹490, you buy back those shares, accumulating a profit of ₹1000. 

However, the price goes up and touches ₹520. You set stop-loss triggers and limit your potential losses to ₹1000 (i.e ₹10*100 shares). 

2. Long Cover Order 

The long cover order strategy is exactly the opposite of the short cover, and traders here take a long position or aim to purchase assets. Contrary to a short position, here the aim of a trader is to purchase at a lower price and sell them later at a higher price if the price of their chosen stock goes up. 

In this type of cover order strategy, traders place a stop loss below the price at which they purchase a certain amount of shares. As you have seen in the earlier example, placing a stop-loss at ₹490 may be your long cover strategy as you anticipate a rise in price. 

What are Some Effective Approaches to Place Cover Orders in Day Trading?

You may wonder, “how do i strategically use a cover order in real time?” For this, you must focus on setting realistic stop losses, rely on technical indicators, factor in volatility, and other approaches. Here is a detailed breakdown of each:

1. Placing a Realistic Stop Loss

Setting it too close to your entry price may not be ideal, as due to normal price fluctuation your position will be closed, impacting your trading strategy. Also, setting it too far may lead to booking a larger loss. 

As a general guideline, traders may consider placing the stop-loss around 1%–3% away from the entry price. However, the right stop-loss level depends on your trading strategy, volatility, and risk tolerance.

2. Factor in Volatility

Assess how much the stock you are trading is moving while trading in an intraday timeframe before choosing your stop-loss level. For instance, a stock that has a higher precise swing may require a wider buffer. 

Conversely, a relatively stable asset may need less room. Align the placement after assessing recent price behaviour of a security and your planned entry or exit levels. This approach may help prevent placing your stop-loss level either unnecessarily tight or excessively wide.

3. Use Technical Analysis 

You must also identify support and resistance levels while making a cover order and place a stop-loss accordingly instead of placing it at a random price. You may use technical indicators such as Average True Range (ATR). This helps to estimate average price movement of a market-linked asset. The Moving Average (MA) helps identify a prevailing price trend. 

These tools generally help you place stop losses with enough room while maintaining your potential level of loss within your risk limit.

4. Using Cover Orders for Breakout Trades

Placing such orders may be effective when you are making a breakout trade. In this, traders generally aim for a significant price move to book potential profit and at the same time want to limit possible market risks. For instance, suppose you see a stock trading between ₹470 and ₹500 for a few days, and it breaks beyond ₹500. 

Here, you may place a buy order for ₹100 shares at ₹505 using a cover order, with a stop-loss at ₹495. This allows you to follow a breakout trading strategy with a cover while limiting your potential losses if the price reverses.

5. Choose the Right Entry Order

Determine whether a market or limit order is best based on how you may want to enter a trade. A market order is generally suitable when immediate execution of trades is a priority. A limit order lets you choose your preferred maximum price you will pay (for buy orders) or accept the minimum price you will accept (for sell orders).  

Consider checking the liquidity of a stock with its prevailing market conditions before choosing an entry order between these two. Also, look for the current price of a stock to decide your entry level in advance. You should avoid choosing a rapidly moving stock. If your preferred price is unavailable, wait for another setup rather than compromising your trade.

Final Thoughts

A cover order is a popular trading strategy, especially for day trades, which allows you to potentially benefit from price shifts and manage losses with strategic stop-loss placements. However, as the market may be unpredictable while trading, you must analyse price moves, trading volume, market trends, and your risk tolerance before entering a position.

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