Definition
“Buy To Close” is a finance term used in options trading. It refers to the action an investor takes to close out an existing short options position by buying equivalent options contracts. The goal is to reduce or eliminate a short position, thereby covering an investor’s exposure and potentially locking in profits or minimizing losses.
Key Takeaways
- ‘Buy To Close’ is a term used in options trading to exit an open short position. It eliminates or reduces a trader’s obligation to fulfill the terms of the option contract which they had previously sold.
- This strategy is utilized when a trader wants to cover a short position, either to cut losses or secure profits. The trader executes a ‘Buy To Close’ order, purchasing the same option contract he/she initially sold to open the short position.
- ‘Buy To Close’ transactions must be accurately reported on income tax returns. As these transactions can have more complexity than typical securities buys and sells, they may lead to various tax implications.
Importance
The financial term “Buy To Close” plays a crucial role in options trading as it refers to the purchase of an options contract to close an open short position.
This allows the investor to decrease or eliminate the risk associated with a previously established short position in the open market through selling to open.
“Buy To Close” is significant for traders seeking to manage risk, exit their short positions, or capture profits before the expiration of the contract.
Without this tool, investors wouldn’t have an official way to counterbalance or close out a short position on an options contract, which could potentially lead to sizeable losses.
Explanation
Buy to close is a strategic move in finance utilized by investors to offset a short position in a given security or option. Essentially, it is an action taken to wind down a position that an investor has been holding and neutralize any further impact it may have on the investor’s portfolio.
This can be a very important tool when investors want to manage their risk or protect their profits in a dynamic market. So, when an investor initially short sells a stock predicting that the price will drop, they may choose to ‘buy to close’ if they believe that the stock’s price could increase in the future, which would result in a loss for the short-seller.
Moreover, the ‘buy to close’ concept is applicable in options trading as well. This action is undertaken when the investor who initially sold a contract wants to exit the market by buying back the same contract.
This is mainly done to close out the position to either seal in the profit or stop further losses. In other words, the ‘buy to close’ transaction is used as a way to ensure a certain amount of loss or gain and give investors a greater measure of control over the outcome of their investments.
Examples of Buy To Close
“Buy to close” is a financial term used primarily in options trading to close an existing short position. Here are three real-world examples about the finance term “Buy to Close”:Example 1: An investor holds a short position on an option contract for 100 shares of Company A at a strike price of $
The market price for Company A’s shares drops to $
The investor decides to “buy to close” the position and buys the same option contract they shorted to close out their position. Example 2: A trader is involved in a short sale of 50 put option contracts of Company B. Subsequently, the trader speculates that the prices are about to rise. In this case, they would “buy to close” the short contracts and exit their position, to prevent further potential loss due to rising prices. Example 3:A hedge fund has a short position in call options for Company C. The Company unexpectedly announces a new product that is likely to increase the stock price. The hedge fund manager makes the decision to “buy to close” their options position and on purchasing the same type of call options, they are able to close their short position, mitigating potential loss.
FAQs for Buy To Close
What is Buy To Close?
Buy To Close is a trading action that a trader can take. It involves buying an option to close out an open short position. It eliminates the obligation in the existing short option position and leaves the trader owning zero options after the trade. This is usually done to take profits or prevent further losses.
When should I use Buy To Close?
You should use Buy To Close when you initially have a short option position and want to close it. This could be either because your view on the underlying security’s direction has changed or because the option’s expiration is nearing, and you want to avoid assignment.
What is the difference between Buy To Close and Sell To Close?
Buy To Close is used to close a short position, while Sell To Close is used to close a long position. When you use Buy To Close, you eliminate a short option position by buying back the option. With Sell To Close, you sell an existing long option position to exit it. Essentially, both actions are used to close an existing position, but the type of position (short or long) determines the action taken.
Is it possible to make a loss with Buy To Close?
Yes, it’s possible to make a loss with Buy To Close. If the market moves against your initial short position and the option’s price rises, you could have to buy back the option for a higher premium than you initially received, resulting in a net loss. However, by using this strategy you can stop further losses by not holding the option until its expiry.
What happens after Buy To Close?
After performing a Buy To Close transaction, your short position in the option will be closed. You will no longer have any obligation to the option holder at expiration. Whether you made a profit or a loss depends on the price you sold the option for initially and the premium you paid to buy it back.
Related Entrepreneurship Terms
- Options Trading
- Short Position
- Call Option
- Put Option
- Contract Expiration
Sources for More Information
- Investopedia: This website is a large financial education platform where you can get a comprehensive understanding of various finance terms including ‘Buy To Close’.
- MarketWatch: This website provides latest stock market, financial and business news. You can also get analysis of the market trends, including ‘Buy To Close’.
- The Motley Fool: A company dedicated to making the world smarter, happier, and richer. They provide various articles and resources about different aspects of finance and investing, including ‘Buy To Close’.
- Fidelity: An international brokerage firm that provides comprehensive financial resources, information and tools including details about ‘Buy To Close’.
