Closing purchase is a transaction where a trader or an investor intends to reduce or close a particular financial instrument.
It is popularly known as “buy to close” among traders, especially option traders.
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What is option trading?
Options trading is the trading of instruments that give you the right to buy (call) or sell (put) a particular security on a set date at a predetermined price (strike price).
An option is basically a contract between a seller and a buyer. To create an option, you need to write a contract.
Traders can also trade their positions in an already existing option.
What is a closing purchase/buy to close?
Closing purchase is a transaction where a trader or an investor wishes to square off a short position or in a series of options.
Option traders use the phrase “buy to close” to refer to a closing purchase. The phrase means that an option trader is selling/closing out either a call or a put option.
How does closing purchase/buy to close work?
Fundamentally, buy to close or closing purchase is the buying back of an asset (normally option contracts) initially sold short. The buy to close order is made to ensure there is no exposure to the asset.
The buy to close order has one main purpose: to close out or terminate a position that a trader opened because they short sold their option contracts. This means a trader needs to have written a contract/option that they short sold.
They use the “sell to open” order to open a short option position.
The buy to close order is used to negate the initial order or to exit the open position.
Buy to open > Sell to close
Sell to Open > Buy to close
Here, the seller hopes for the price of the asset to go lower to make profit when the trade closes. To exit the position by the pre-agreed date, the seller buys back the position that they created in the first place.
Thus, the loop is completed at the source–the trader who is also the option writer. Thus, the trader is no longer exposed to risks or bound by a contract.
In other words, an option trader will use the buy to close order only if he or she is the writer of that option and wants to exit the option market chain.
Examples of Closing Purchase/Buy to Close
A trader secures a position by writing puts on X stock currently priced at $200. The trader may short sell options with the hope that the price of the underlying asset will go up.
The trader places a sell to open order at a strike price of $200, expiring in 21 days and receives a $10 premium (credit).
On day 20, X stock trades at $202. The contract’s value has dropped significantly as the strike price is lower than the stock price and since there is not much time left until the delivery. At this point, the trader places a buy to close order at $3.
Thus, the trader short sold to open at $10 which he bought to close at $3, realizing a profit of $7.
What’s the difference between buy to open and buy to close?
Buying to open involves entering a new options contract and securing your position within it.
On the other hand, buying to close involves ending an existing contract and squaring off your position and reducing your risk.
Buy to Open | Buy to Close |
|---|---|
Creates a new options contract | Terminates an existing options contract |
Establishes a long options contract | Covers an existing short options contract |
Has high reward potential | Takes advantage of time decay |
Can be used with puts or calls | Can be used with puts or calls |
Trader pays a premium to secure a position | Trader is paid for writing an options contract |
More about shorting position in an asset
A short position is a trading technique where a trader sells a security with the intention to buy it back later.
This strategy is used when a trader anticipates a drop in the price of a security in the short term. If the price drops as anticipated, the trader can buy the stock/options at a lower price and make a profit.
Short positions can be divided into the following types:
- Naked short: When a trader sells a security without having possession of it
- Covered short: When an investor buys stock shares to close out an open short position
Conclusion
Buy to close is a transaction order used when a trader is net short an option position and wants to end that open position. It reverses the initial trade where you received a credit or premium from short selling options. It is important to note that a put buyer can lost his entire investment if the underlying security doesn't decline below the strike by expiration. However, the loss is locked at the initial investment value.
Key takeaways:
- The buy to close transaction order is used if the trade was originally opened using a sell to open order.
- The main purpose of the buy to close transaction is to exit a position that a trader opened by short selling their options contracts.
- Buy to open > Sell to close; Sell to Open > Buy to close.
- A buy to close order takes advantage of time decay.