It is important to know what these terms mean. Additionally, you need to know under what circumstances to buy and open and when to buy and close.
(There is a similar post for the opposite trade: Sell To Open vs Sell To Close)
What is Buy and Open?
The term “open” comes from the fact that you open a position when you start trading. Therefore, buying and opening means that you are buying the option to open a position.
Whenever you buy a new long call or long put, you should use a buy-to-open order. This may indicate to other participants in the market that you have discovered the potential of the market, especially if you are placing large orders. However, it is equally possible to use buy orders for spreads or hedging if you only place small orders.
Let’s apply this to reality. Suppose you buy a call option whose underlying stock is trading at a premium of $1.30 and expires two months ahead of him. Let’s say the trade price is $50 and the strike price at the time of the call is $55. Buy-to-Open orders must be used to purchase this call option through a brokerage firm.
When it comes time to close out the position, you should use a sell order. You can do this at any time. It can even be the day after using a buy to open order. In the example above, if the underlying stock price rises perhaps to $57 before reaching the expiration date, you can choose to sell and close. An open option is closed using a sell-to-close order.
Please note that buy orders are not always filled. This can occur if the exchange restricts orders to be closed only in certain market conditions. An example of such a market condition is when the underlying stock of the option you are purchasing is scheduled to be delisted. Another reason is that exchanges don’t trade stocks for a while.
What is Buy to Close?
As we saw above, buy to open (and sell to close) applies to long calls and puts. A short position requires a buy to close (and a sell to open). In other words, Sell-to-Open orders are required to establish new positions with short calls and puts.
Selling and opening requires collateral for the position. This can take the form of corresponding stock or cash equivalents. If you own a stock, you share the covered position. If you don’t own the stock, you are either shorting the option or selling the naked position.
Then, if you want to close your position, you should use a Buy-to-Close order.
Selling to open is very easy. Let’s take a closer look at what it means to buy to close.
First, you must remember that selling short an option means writing a contract to sell to another buyer. Your objective is to see a decline in the underlying stock price. This will give you a profit when the trade is closed.
A trade ends when it reaches maturity, buys back the position, or when the buyer exercises the option. (Exercise of an option involves conversion into shares, which is rare.) If the sell or short price is higher than the buy or cover price, you make a profit.
Buying to close closes an already existing short position. In other words, you have an open position that has received net credit. By writing that option you are closing the position.
Sell and open, buy and close example
Let’s apply all of this (both sell to open and buy to close) to another example. You decide that the price of ABC stock is likely to rise and you want to take advantage of this opportunity to make a profit. Therefore, you must sell to open a $1.50 put contract. Let’s imagine you’re right in this scenario: inventory increases. This gives the put a value of $0.75. So your profit will be:
$1.50 – $0.75 = $0.75
Now let’s say the position does not expire in 2 weeks. Since we want to secure a profit, we need to close the position. This means that you should use Buy-to-Close orders. that’s all. You will receive a profit of $0.75.
buy to cover
One thing to note is that buying to close is not the same as buying to cover. The difference is that buys to close are usually options and sometimes futures, whereas buys to cover are only stocks. However, both result in the repurchase of the asset that was originally shorted, meaning that the exposure to the asset is gone.
Buy-and-Open or Buy-and-Close: When to Use Each
Now that you understand the difference between Buy to open and Buy to close, all that remains is to clarify when to use them.
When should investors buy to open?
Whenever you want to buy a call or put to profit from price movements of the underlying asset, you have to buy it to get started. Taking a buy-to-open position helps to hedge or offset portfolio risk. It is particularly effective to use a buy out-of-the-money put option to buy and open the underlying stock at the same time.
All in all, buying to start gives you the opportunity to make a significant profit. Moreover, in the event of losses, these will be minimized. Of course, there is always the risk that a buy to open position will become worthless by the expiration date due to time decay.
When should the seller buy and close the transaction?
As an options seller, time decay is in your favor. Nevertheless, there may be times when you want to close a position before it expires. His one example of when this is the case is in the case of price increases in the underlying asset. If this happens, buying to close may give you early access to profit.
For example, let’s say you’re selling an at-the-money put that lasts 12 months. Then after 2 months the underlying assets increase by 15% of his. You can use the buying opportunity to close and access the majority of your profits immediately.
Alternatively, you can reduce your potential losses by buying to close. Let’s go back to the same scenario of the at-the-money put above. But this time, instead of increasing the underlying asset by 15%, let’s say it decreases by that amount. You can decide to buy to close at this point to avoid even bigger losses that could result from waiting longer.
Long and short options on the same position
Some strategies can carry both a long option on an asset and a short option on an asset at the same time. This helps in getting the opposite position without having to close the original open position. In other words, you profit when the underlying asset price moves in the right direction, but it also reduces your risk compared to buying a single option.
You can buy long and short options separately, but if you use a brokerage firm that specializes in options, you may be able to participate in the strategy as a single trade.
So if you have a strategy with multiple long and short options, what should you use? Buy to open (and sell to close) or buy to close (and open to open)? (sell to)? The answer is that it depends.
Strategies such as Bull Call Spread, Bear Put Spread, Long Straddle, and Long Strangle use Buy-to-Open orders. This is to open these strategies with a net debit. That is, you pay to open a position. We also use Sell-to-Close orders as we do for long positions.
Conversely, whenever you receive net credit for your strategy, you should use sell-to-open and buy-to-close orders, just like you would for a short position. Strategies that fall into this category include bull put spreads, bear call spreads, short straddles, short strangles, and iron condors.
Buying at the start and deciding when to buy at the end sounds pretty straightforward. However, like all options trading, calculations are required to predict how the price of the underlying asset is likely to change. This becomes even more complicated when you have an options strategy that includes both long and short options. In such cases, you need to consider the overall position to make the right decision.
About the Author: Chris Young has a degree in Mathematics and 18 years of experience in finance. Chris is from the UK, but he has worked in the US and most recently in Australia. His interest in options was first aroused by the “Trading Options” section of the Financial Times (London). He was determined to spread this knowledge to more people and in 2012 he founded Epsilon Options.