Definition and How It Works in Options Trading

What Is Buy to Close?

“Buy to close” refers to terminology that traders, primarily option traders, use to exit an existing short position. In market parlance, it is understood to mean that the trader wants to close out an existing option trade. Technically speaking, it means that the trader wants to buy an asset to offset, or close, a short position in that same asset.

Understanding Buy to Close

There is a nuanced difference between a buy-to-close option and a buy-to-cover purchase. The former refers mainly to options, and sometimes futures, while the latter typically refers to stocks only. The end result is the same in both cases. Essentially, it is the buying back of an asset initially sold short. The net result is no exposure to the asset.

The term buy to close is used when a trader is net short an option position and wants to exit that open position. In other words, they already have an open position, by way of writing an option, for which they have received a net credit, and now seek to close that position. Traders normally use a “sell-to-open” order to establish this open short option position which the “buy to close” order offsets.

In the case of stocks, selling assets short involves borrowing the asset from another entity. For futures and options, the process involves writing a contract to sell it to another buyer. In both cases, the trader hopes the price of the underlying stock moves lower to generate a profit at the trade’s closing.

For stocks, the only way to exit the trade (barring bankruptcy in the underlying company) is to buy shares back and return them to the entity from whom they were borrowed. In a futures transaction, the trade ends at maturity or when the seller buys back the position in the open market to cover their short position. For an options position, the trade ends at maturity, when the seller buys back the position in the open market, or when the buyer of the option exercises it. In all cases, if the purchase or cover price is less than the selling or shorting price, there is a profit for the seller.

Selling Short Against the Box

It is possible to carry a short position in an asset and a long position in the same asset at the same time. This strategy is called shorting against the box or selling short against the box. This allows an opposite position without forcing the trader to close out their initial open position, which differs from a “buy-to-cover” order.

There are many reasons why traders would do this, but the primary purpose is to maintain the history of the long position. For example, a stock held in an account for many years might have a sizable unrealized profit. Instead of selling it to take advantage of short-term market conditions and triggering a tax liability, the trader can short the stock by borrowing the shares, usually from their broker.

It is important to note that not all brokers allow this type of transaction. Additionally, changes in taxation rules trigger the liability at the time of the short sale. Therefore, while it is possible to do, this sort of transaction is no longer desirable or practical. The same applies to holding a short position and then attempting to purchase a long position. Most brokers will merely offset the two positions, essentially creating a buy-to-close situation.

The Bottom Line

Buy to close gives options traders a way to exit a short position by buying an options contract that offsets it. This contract is identical to the one they wrote or sold, and allows them to capture profits or mitigate risk.

As with all derivatives transactions, trading options by buying to close comes with risk, so make sure you understand this risk, the mechanics of the trade, and how it can affect your overall strategy before you begin.