Buy to open vs buy to close is not something you want to get wrong. So today, we’ll look at exactly what the two terms mean.
Contents
An option is a contract between two parties for the right, but not the obligation to buy or sell a certain amount of an underlying asset, at an agreed-upon price (the strike price), by an agreed-upon date (the expiration date).
Like stocks, an option trader can decide to go long (betting on the price rising) or short (betting on the price falling).
Since options involve the use of contracts between two parties that can be subsequently traded on a market, there are two different ways that an options trader can decide to enter into a position.
These are:
- Buying or selling a completely new options contract
- Buying or selling an options contract that already exists
This gives an options trader flexibility and further considerations when entering a position, opening up the number of potential options they can trade with.
There are four ways to enter a trade, which are the:
- Buy To Open
- Buy To Close
- Sell To Open
- Sell To Close
This article will explore the ways in which a trader can buy an options contract, and so it will cover the two order types that permit this – the Buy To Open and The Buy To Close.
A future article will explore ways in which a trader can sell an options contract, covering Sell To Open and Sell To Close order types.
Buy To Open
A Buy To Open is one of two possible ways that an option position can be opened (the other is the Sell To Open).
A Buy To Open is used when a trader wants to go long the option – that is to say, they believe the value of the option will increase.
When executing a Buy To Open, a trader is creating a new options contract in the market.
With this type of order, the cost of the option (called the premium) is debited from the trading account and the trader is awarded with a long position in the market.
A Buy To Open can be used to buy both a call and a put and it works in the same way for both.
When a Buy To Open is used for a call position, it means the trader is hoping for the price of the underlying stock to rise, which increases the value of the call option.
If a Buy To Open is used for a put position however, it means that the trader is hoping for the price of the stock to fall, which will also increase the value of the option.
Remember, the Buy To Open means the trader is going long the value of the option, not the value of the underlying.
Regardless of whether you use a Buy To Open order for a call or a put, to close out the position, you will need to buy the call or put option back which is done by executing a Sell To Close order.
Buy To Close
A Buy To Close order differs from a Buy To Open order in two main ways.
The first is that you are trading a position in an options contract that was created previously.
The second is that the order is used when you are seeking to close the position, rather than open a new one.
Simply put, whenever a Sell To Open order is placed (which involves the creation and sale of a call or put option), a Buy To Close is required to close the position.
When a call or put option is sold, it places the trader in a short position and provides them with some money upfront for creating the option (i.e. they receive an option premium).
After some period of time, the position may move into a profit or loss and the trader might desire to close out their position before expiration.
In order to do so, they would need to buy back the options that were sold, which would require them to execute a Buy To Close order.
When this occurs, the trader will effectively be paying for someone else to take over the position.
The new owner of the position can then hold it to expiration (to exercise the option or let it expire worthless) or close their position before expiration through a similar Buy To Close order.
Conclusion
A Buy To Open order is used when a trader wishes to enter into a new long position, where they are betting on the value of the option rising.
A Buy To Close order is used when a trader is seeking to close a short position that already exists.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
