In the bountiful fields of options trading, two integral techniques emerge, much like the cyclical phases of farming: ‘buy to open’ and ‘buy to close’. They are as critical and interrelated as the sowing and harvesting processes performed by farmers.
Imagine ‘buy to open’ as the act of sowing seeds in the fertile ground, representing the initiation of a new long position in a call or put option. Each seed, bolstered by the trader’s optimism towards favorable market conditions, aspires to sprout, grow, and ultimately bear fruit in the rich expanse of investment opportunities.
On the other hand, ‘buy to close’ resonates with the moment when ripe fruits are harvested, marking the closure of an open short position. Similar to how the farmer identifies the perfect time to harvest based on shifting seasonal cycles or the fruit’s maturity, the trader too discerns it’s the right time to exit, perhaps due to a change in market conditions or the fruition of their strategy.
The strategies of ‘buy to open’ and ‘buy to close’, like the art of farming, combine simplicity and complexity in intriguing ways. You might wonder, how can these agricultural forces of trading be utilized to yield the most profitable harvest in the market? We’re going to give you an in-depth guide for options traders so you have everything you need to understand buying to open, buying to close, and how they compare.
What you’ll learn
What Exactly is Buy to Open?
“Buy to open” is a term that’s unique to the world of options trading. At its core, it’s an instruction to your broker, signaling the establishment of a new long position in options. To put it simply: if you’re planning to purchase a new call or put option, you would place a ‘buy to open’.
For example, let’s say an investor believes that Bank of America (BAC), currently trading at $30, is going to rise in the next couple of months. To take advantage of this potential rise, they decide to purchase a call option. This call option gives the right (but not the obligation) to buy 100 shares of BAC at a predetermined price, say $32.50, before a specific date. To initiate this new position, they place a ‘buy to open’ order. Later, if they decide to exit this position, they’ll place a ‘sell to close’ order.
What about setting up a short position?
There are several different types of orders related to options trading. In the case of a short, a trader is required to use a ‘sell to open’ order and to close that position later, they’d use a ‘buy to close’ order. For instance, if a trader is anticipating that a stock’s price will fall and wishes to sell a call or a put option, they would use the ‘sell to open’ option.
Now, the use of ‘buy to open’ isn’t limited to simply initiating a new options position. It can also serve as a strategic tool for hedging other risks in your portfolio. Hedging is when an investor offsets potential losses from one investment by making another investment.
Lastly, keep in mind that while a ‘buy to open’ position can offer significant gains with potentially minimal losses, there’s also a higher risk of the option expiring worthless.
What is Buy to Close?
In essence, this strategy refers to the action of a trader looking to wrap up an ongoing short position in an option. Here, the term ‘short position’ refers to a situation where the trader has sold an option they didn’t previously own.
To clarify the concept, ‘buy to close’ is invoked when an options trader, who currently has a net short position in an option, decides to withdraw from that position. The trader is seeking to neutralize an open position created earlier by writing an option. For this initial open position, they had received a net credit. However, they now wish to close this position, and to do so, they use a ‘buy to close’ order.
It’s worth noting that ‘buy to close’ and ‘buy to cover’ purchases are similar but not identical. ‘Buy to close’ primarily refers to options and, at times, futures, while ‘buy to Cover’ pertains exclusively to stocks. Despite the slight variation in terminology, the ultimate goal in both scenarios is the same: repurchasing an asset that was initially sold short, resulting in zero exposure to that asset.
As part of some basic options strategies, there are different ways to close a short position, depending on the type of security. For stocks, the only escape route, barring the underlying company’s bankruptcy, is to repurchase the shares and return them to the original lender. In futures, the trade culminates at maturity or when the seller repurchases the position in the open market to cover their short. In options trading, the position can be closed at maturity, when the seller repurchases the position in the open market, or when the buyer exercises the option. Profit arises for the seller if the buyback is lower than the selling or shorting price.
The chart above shows that the type of transaction changes depending on if you are the buyer or seller, and if you are going to open or close a position.
Comparing the Differences: Buy to Open vs. Buy to Close
In the realm of trading, an act of buying could denote the establishment of a new position or the conclusion of a pre-existing one. ‘Buy to open’ and ‘buy to close’ might seem somewhat alike in the mechanics of their processes, but they serve distinct purposes. Here are some of the distinguishing features of ‘buy to open’ vs ‘buy to close’:
Differences of “Buy to Open” and “Buy to Close” compared.
Pros and Cons of Buy to Open and Buy to Close
Each of these trading strategies has its benefits and drawbacks. Let’s dissect them:
Buy to Open
Pros:
- Flexibility: ‘Buy to open’ allows traders to bet on either a rise or fall in the price of an asset, depending on whether they’re buying a call or put option.
- Limited Risk: When buying an option, the maximum possible loss is limited to the premium paid for the contract.
- Leverage: Options provide leverage, offering the potential for a higher percentage return relative to the initial investment.
Cons:
- Potential for Total Loss: If the option expires worthless, the entire initial investment can be lost.
- Time Decay: The value of options decreases over time, all else being equal. This time decay, which is measured through an option’s Theta, can erode the value of your position. Not monitoring this appropriately is a common mistake by beginner traders.
- Paying Premiums: ‘Buy to open’ orders involve paying premiums whereas ‘buy to close’ orders involve receiving premiums.
Buy to Close
Pros:
- Position Closing: This order type enables traders to close out an existing short position, reducing exposure to a potentially wrong market prediction.
- Profit Locking: If a short position has become profitable, ‘buy to close’ allows the trader to secure that profit before expiration.
- Loss Control: ‘Buy to close’ can help limit losses if the market moves against a short position.
Cons:
- Market Timing: Successful execution of ‘buy to close’ requires accurate timing, or traders risk losing potential profits.
- Transaction Costs: Each transaction incurs broker fees, which can eat into profits.
- Short Squeeze Risk: In volatile markets, heavy buying activity can drive up the price of the underlying asset, causing losses for those needing to close short positions.
Buy to Open vs. Buy to Close – When Should You Use Each?
‘Buy to open’ is typically used when a trader intends to establish a new options contract, such as a call or a put, reflecting their bullish or bearish outlook on the underlying asset. This order allows the trader to profit from anticipated price fluctuations in the asset. Additionally, a ‘buy to open’ order can be instrumental in hedging strategies, serving to offset potential risks in the trader’s portfolio.
Hedging, in essence, is a protective strategy where a trader makes a secondary investment to potentially counterbalance losses from their primary investment. For example, a trader may choose to ‘buy to open’ a put option out-of-the-money, at the same time as buying the underlying stock. This advanced strategy for experienced traders allows the trader to limit potential losses on the stock by profiting from the put option if the stock price decreases.
On the other hand, a ‘buy to close’ order comes into play when a trader wishes to conclude an existing short position in an options contract. This can occur in scenarios where the trader seeks to lock in profits early, or limit further losses in case the market moves unfavorably.
For instance, let’s imagine that a trader sold a put option (establishing a short position), expecting the underlying stock price to rise. However, if the stock price does begin to fall unexpectedly, the put option the trader sold could increase in value, leading to potential losses for them. To mitigate these losses, the trader can execute a ‘buy to close’ order, effectively canceling their initial short position by purchasing an equivalent put option. In doing so, they eliminate their obligation to buy the underlying stock at the strike price, curbing their potential losses.
Conclusion
In the vast realm of options trading, ‘buy to open’ and ‘buy to close’ remain the cornerstones, akin to the fundamentals of sowing and harvesting in the agricultural world. They provide traders with the means to initiate and conclude positions in the options market. ‘Buy to open’ offers an opportunity to establish new long or short positions with the potential for considerable gains, coupled with the risk management capability of hedging. Meanwhile, ‘buy to close’ provides the ability to curtail an existing short position, enabling traders to mitigate potential losses or secure profits before the contract’s expiration.
Understanding these strategies, their advantages and pitfalls, and knowing when to deploy each is crucial to navigating the fluctuating currents of the options market. Like a seasoned farmer who discerns the perfect time to sow and harvest, successful traders require the wisdom to discern when to ‘buy to open’ and when to ‘buy to close’. It is this duality, when mastered, that can help traders maximize their harvest in the vast and fertile field of options trading.
Understanding these foundational strategies is vital for both novice and experienced investors. If you find it difficult to decipher these strategies, consider subscribing to an options trading alert service to receive notifications directly from experienced traders. By incorporating ‘buy to open’ and ‘buy to close’ into their trading repertoire, investors can strengthen their ability to react effectively to market fluctuations, ultimately enhancing their investment strategies and, hopefully, their overall returns. The cyclical dance of sowing and harvesting, opening and closing, remains at the heart of the market, a testament to the intricate and rewarding world of options trading.
Buy to Open vs. Buy to Close: FAQs
What Does “Buy to Open” Mean?
The term ‘buy to open’ indicates the initiation of a new long position in an options contract. Essentially, it is the command given to your broker to purchase either a call or a put option, establishing a fresh position in that options contract. ‘buy to open’ orders are used when an investor has an idea of the direction of the underlying price and wants to capitalize on it.
What Does “Buy to Close” Refer to?
‘Buy to close’, as a term, is used when a trader desires to exit a current short position in an options contract. Namely, you’re instructing your broker to buy back an options contract to effectively close out a short position that was previously opened. ‘Buy to close’ orders are not necessarily bullish or bearish, they’re just used most often when an investor either wants to lock in profits and/ or protect from losses.
How Does ‘Sell to Open’ Differ From ‘Buy to Open’?
‘Sell to open’ and ‘buy to open’, despite seeming similar, serve unique purposes in trading. ‘Sell to open’ is utilized when initiating a short position, meaning you’re selling an options contract with the belief that the price of the underlying asset will fall. Conversely, ‘buy to open’ is used to commence a long position, where you’re buying an options contract in anticipation of the price of the underlying asset rising.
Is it Preferable to ‘Sell to Open’ or ‘Sell to Close’?
The choice between ‘sell to open’ and ‘sell to close’ hinges on your current trading stance and the direction you anticipate the market to take. You’d use ‘sell to open’ when your objective is to initiate a short position, commonly when foreseeing a slump in the price of the asset. Conversely, ‘sell to close’ is the order you’d place when the aim is to wind up a long position, typically when you’ve garnered profits or desire to curtail losses.
How Can I Determine Which Order to Use When Trading Options?
The determination of which order to use in options trading primarily revolves around your market prediction and the strategy you’re employing. If you’re of the view that the asset’s price will ascend, you might lean towards a ‘buy to open’ order. In contrast, a ‘sell to open’ order could be your go-to if you’re predicting a downward trend in the price. When it comes to closing out positions, ‘buy to close’ serves to exit short positions, and ‘sell to close’ is employed for exiting long positions. Familiarity with these terms and their implications plays a crucial role in navigating the options market effectively.
