April 7

Buy to Open and Buy to Close: What Is It, and How Does It Work?

0  comments

Last Updated on 7 April, 2022 by Samuelsson

Buy to Open and Buy to Close: What Is It, and How Does It Work?

Whether you are trading the options market for the first time or you have been trading for a while, you’ll probably come across the terms “buy to open” and “buy to close”. But what do they really mean, and how do you use them?

Buy to Open and Buy to Close are terms used by options brokers to indicate the nature of an order placed by a trader. Buy to Open indicates that a new long (call or put options) position has been opened, while a Buy to Close indicates that an existing short (call or put options) position has been closed (covered).

To explain these terms, we will discuss them under the following subheadings:

  • What Is Buy to Open?
  • What is Buy to Close?
  • Buy to Open vs. Buy to Close
  • Using Buy to Open and Buy to Close in the equity market

What Is Buy to Open?

Buy to Open is a term options brokers use to indicate a new long call or put options position. That is, if an options trader wants to buy a call or put position, the trader will buy to open a trade. The new order he opens is known as Buy to Open. Thus, a buy-to-open order indicates to the market that a trader is establishing a new long position rather than a new short position or closing out an existing position. Opening a new short position would mean Sell to Open, while closing out an existing long position would mean Sell to Close.

In essence, options traders use the Buy to Open trade order when they want to purchase a call or put option. Buy to open lets traders buy the right to establish a long or short position in the underlying security. To buy this right, they have to pay the option premium, which is immediately debited from their account. If a trader buys a call option, the underlying security price must increase enough to push the call option price past the break-even point for them to make a profit. In the case of a put option, the underlying security price must fall enough to drive the put option price below the break-even point. To close out the options trade, the trader must sell the call or put options back using a Sell to Close trade order.

Understanding Buy to Open

To understand the Buy to Open order, we need to understand how options trading works. Options trading refers to buying or selling options contracts. An options contract gives traders the right — but not the obligation — to buy or sell the underlying asset at an agreed price within a pre-determined period of time.

When the contract gives the buyer the right to buy the underlying asset at an agreed strike price, it is called a call option. On the other hand, when the contract gives the buyer the right to sell the underlying asset at an agreed strike price, it is called a put option.

Whether it is a call option or a put option, every option is essentially a contract between a buyer and a seller. But among speculators, it is just a bet between a buyer and a seller regarding the price direction of the underlying asset in the future. Since it doesn’t deal directly with the underlying asset, options are derivative contracts.

There are options contracts for stocks, ETFs, indexes, and commodity futures. One options contract controls a fixed amount of the underlying security. For example, one options contract controls 100 shares of stock. Traders tend to choose options contracts over directly trading the underlying asset, such as stocks, because they are less expensive to trade than the underlying security. When they buy a call or put option, they limit their risk to the option’s purchase price and the broker fees.

Options traders have more choices when it comes to opening and closing a trade than those who directly trade the underlying assets do. However, unlike stocks, options are wasting assets — the value of an option decreases the closer it gets to the expiration date. A trader’s risk depends partly on whether you’re buying the option or selling it.

Now, back to Buy to Open transactions, they are designed to take advantage of upward trends. Traders place Buy to Open orders when they are going long on an option contract, which means they believe the option’s value will increase over time. When they execute the Buy to Open trade, they create new options contracts in the market.

There are two ways to use the Buy to Open option: a trader can use it to open a long call position or a long put position. If a trader places a Buy to Open position on a call option, it means he is buying the right to buy the underlying asset at a certain price (strike price) because he is expecting the underlying asset’s prices to rise above that price, which increases the price of the option. On the other hand, if a trader places a Buy to Open position on a put option, he is buying the right to sell the underlying asset at a certain price because he is expecting the underlying asset’s price to fall, which increases the put option’s value.

In a nutshell, Buying to Open means that the trader is opening a new long position (buying the right) in an option and pays the premium now to secure that position.

Examples of Buy to Open

Now, let’s consider a Buy to Open example. Let’s say that a trader has performed some analysis on the market and believes that the price of Stock Q will go from $100 to $150 within the next 6 months. This trader can place a Buy to Open order on a call option for Stock Q with over 6 months expiration date at a strike price of say $120.

Within the duration of the contract, this trader can exercise his right to buy Stock Q at $120 per share and resell those stocks at a higher price if the price has risen toward $150 per share as he expected. Also, he could close out his contract by reselling the contract (Sell to Close) to a new buyer.

What is Buy to Close?

Buy to Close is a term that options traders and brokers use to indicate closing an existing short position. The term is used when a trader is net short an option position and wants to exit that open position. So, it indicates that the trader wants to close out an existing short position in an option trade, and as the name implies, it means that the trader wants to “buy” an asset in order to offset, or close, a short position in that same asset.

To put it differently, the trader already has an open position, by way of writing an option, for which they have received a net credit, and now seek to close that position. The open position was created with a Sell to Open order, so to close it, the trader would use a Buy to Close order.

Understanding Buy to Close

To understand Buy to Close, you need to understand how short selling works in options. Every option is a contract between a seller and a buyer. The seller is selling a right to the buyer to either buy or sell the underlying asset to him on a future date at an agreed strike price.

As you already know, there are two types of options contracts: call options and put options. When a trader sells a call option, he is selling, to the buyer, the right to buy the underlying asset from him on a future date at a given strike price. For a put option, the seller is selling, to the buyer, the right to sell the underlying asset to him on a future date at a given strike price.

In any case, the buyer pays him a premium to the seller to buy that right and hopes to exercise the right if the underlying asset’s price moves as the buyer expected (upwards for a call option and downward for a put option). On the other hand, the seller’s expectation when selling a call option is that the underlying asset’s price will drop so that the buyer doesn’t exercise the right to buy the underlying asset, and when selling a put option, the expectation is that the price of the underlying will increase so that the buyer doesn’t exercise the right to sell the underlying asset.

The interesting thing about options is that both parties can offset their trades by passing them off to another trader. So, if the seller wants to offset his position, he can buy back the exact contract from the exchange. Buying back a contract to offset a short position is known as Buy to Close. It doesn’t matter if the short position was a call contract or a put contract; the seller simply buys the exact contract to offset his position. SO, if he sold a call contract initially, he would have to buy (Buy to Close) a call contract to offset the position, and if he sold a put contract, he would buy (Buy to Close) a put contract to offset it.

Examples of Buy to Close

Let’s see what Buy to Close looks like with these three scenarios:

1. Closing a short call

Let’s say a trader who initially wrote a short call contract wants to lock in a profit (or take a small loss if he thinks the underlying asset’s price will keep rising). The trader can choose to close out the call before expiration. To do this, he will need to “Buy to Close” the short call he initially wrote. He may also have to consider the worth of the option; hopefully, it will be worth less than what he initially sold it for.

2. Closing a short put

This is just as closing a short call, but in this case, the trader initially wrote a short put. When selling the put contract, the trader hoped that the underlying stock would close above the strike price of the put so that the put, in turn, would expire worthless, allowing him to pocket the premium he received for selling the put contract.

However, if the market condition changes and the trader anticipates that the stock will trade below the strike price, he can “Buy to Close” so as to offset the contract and prevent the put contract from being exercised against him.

3. Bull Put Spread

This kind of contract consists of one short put (Sell to Open) and one long put (Buy to Open) at a lower strike price. It forms a credit spread that achieves its maximum profit, provided the stock price closes above the strike price of the short put. If the stock closes above the higher of the two strike prices, then both puts (long and short) will expire worthless, and the trader will have no other obligation.

However, if the trader anticipates that the stock will close below the strike price of the short put (the one that was sold to open), he will most likely want to close the entire bull put spread. He can do that by simply reversing the action of the initial trades — that is, he “Buys to Close” the put he sold and “Sells to Close” the second put bought.

Buy to Open vs. Buy to Close

When a trader buys, he may be opening a new position or closing an existing one. While buying to open and buying to close might seem a bit similar in terms of processes, they differ. It is, therefore, important to know the circumstances when traders Buy To Open and when they Buy to Close. Here are the key points about Buy to Open and Buy to Close:

Buy to Open Buy to Close
Used by option buyers Used by option sellers
It is for a new long position It is used when there’s an existing short position.
It is used by a buyer to open a new options position. It is used by a seller to close an existing options position.

Buy to Open vs. Buy to Close


Tags


You may also like

The History of Algorithmic Trading

The History of Algorithmic Trading
{"email":"Email address invalid","url":"Website address invalid","required":"Required field missing"}