Buy to Close
The purpose of a buy to close transaction is to close out any short option position that required you to sell to open in order to initiate the trade. In this way, the process is similar to short selling stock. You initiate a trade by selling something first (and receiving cash) and then later you close the trade by buying it back.
To illustrate, please see the three examples below.
Buy to Close Examples
Here are three quick examples:
- Covered Call - If you decide to close out a covered call prior to expiration (either to lock in a gain or take a loss), you will need to buy to close the short call you initially wrote. Hopefully, the option will be worth less than what you originally sold it for when it's time to buy it back.
- Writing Puts - Closing a short put works the same way as closing a short call (see above). When you originally wrote, or sold, a naked put you received a cash premium and, no doubt, hoped that the underlying stock would close above the strike price of the put so that the put, in turn, would expire worthless.
If, however, you anticipate that the put will retain value at expiration (i.e. the stock will trade below the strike price), and if you're unwilling to allow the put to be exercised against you, then you will have to buy to close in order to close out the transaction.
- Bull Put Spread - A bull put spread consists of one short put (sell to open) and one long put (buy to open) at a lower strike price. This forms a credit spread that achieves its maximum profit as long as the stock price closes above the strike price of the short put. If the stock does close above the higher of the two strike prices, then both puts (long and short) will expire worthless and you will have no other obligation than to pat yourself on the back.
If it looks like the stock will close below the strike price of the short put (the one you sold to open) then you will most likely want to close the entire bull put spread. And you do that by simply reversing the action of the initial trades. The put you sold to open must be bought back to close, and the second put which you purchased (buy to open) at the lower strike price must be sold to close.