Mastering Buy to Close: A Comprehensive Guide to Exiting Short Positions

Buy to close is a term commonly used by traders, especially those involved in options trading, to describe the process of exiting an existing short position. In other words, it involves buying an asset to counteract a previously established short position in that same asset.

While buy to close primarily applies to options and sometimes futures, it’s essential to distinguish it from a buy-to-cover purchase, which typically pertains to stocks. Despite this difference in terminology, the ultimate outcome in both scenarios is the same – the acquisition of an asset initially sold short, resulting in no exposure to that asset.

Traders employ the term “buy to close” when they are net short an option position and wish to exit that open position. This typically occurs after they have initially written an option, receiving a net credit, and now intend to close out that position. To establish an open short option position, traders usually use a “sell-to-open” order, which the “buy to close” order subsequently offsets.

When dealing with stocks, short selling involves borrowing the asset from another entity. In contrast, for futures and options, it entails writing a contract to sell it to another buyer. In both cases, the trader anticipates that the underlying asset’s price will decrease, resulting in a profit when closing the trade.

For stocks, the only way to exit a short trade is by repurchasing the shares and returning them to the entity from which they were borrowed, unless the underlying company declares bankruptcy. In futures trading, the trade concludes either at maturity or when the seller repurchases the position in the open market to cover their short position. In options trading, closure can occur at maturity, when the seller repurchases the position in the open market, or when the option buyer exercises it. In all cases, if the purchase or cover price is lower than the selling or shorting price, a profit is realized.

Traders have the option to maintain both a short position and a long position in the same asset simultaneously, a strategy known as shorting against the box. This strategy enables traders to hold an opposing position without closing their initial open position, a practice that distinguishes it from a “buy-to-cover” order.

Various reasons might lead traders to employ this strategy. For instance, if an investor has held a stock in their account for an extended period and it has accrued a substantial unrealized profit, they may choose to avoid triggering a tax liability by shorting the same stock through borrowing shares, usually from their broker.

It’s important to note that not all brokers permit this type of transaction, and changes in taxation rules may result in the immediate recognition of tax liability at the time of the short sale. Consequently, while this transaction is possible, it may no longer be practical or desirable. The same applies to initiating a long position after holding a short position; most brokers will merely offset the two positions, essentially creating a buy-to-close situation.

Understanding the concept of “buy to close” is essential for traders, especially those navigating the complex world of options and futures. It’s a strategic move that allows traders to manage their positions effectively and respond to market dynamics.

The primary purpose of “buy to close” in trading is to exit an existing short position, particularly in options trading. It involves purchasing an asset to offset a short position, effectively nullifying exposure to that asset.

While both terms involve purchasing an asset initially sold short, “buy to close” is primarily used in options and sometimes futures trading, whereas “buy-to-cover” typically applies to stocks. The outcome, however, is the same – the elimination of exposure to the asset.

Shorting against the box can have tax implications, and the rules may vary depending on your jurisdiction. In some cases, it might trigger tax liability at the time of the short sale, potentially affecting your overall tax situation. It’s advisable to consult a tax professional for guidance on your specific circumstances.