Buy to Open vs. Buy to Close: What It Means and How It Works in Real Life
In the world of stock market trading, it’s important to understand the terms “buy to open” and “buy to close,” as well as “sell to open” and “sell to close.” Whether you’re a novice investor or a beginner in online trading, these concepts play a significant role. This article will delve into these terms and provide relatable examples to help you grasp their meaning.
Before we dive into the specifics of buy to open and buy to close, let’s establish a foundation by understanding options trading. Essentially, an option represents a contract between a buyer and a seller. This contract grants traders the right, but not the obligation, to buy or sell shares at an agreed-upon price within a specified timeframe.
Think of options as a form of bet between a buyer and a seller, where they speculate on the price movement in the future. For instance, let’s say you believe that self-driving cars will become more affordable than traditional cars in the next five years, but the seller disagrees. In this scenario, you can create an options agreement that grants both parties the option to buy or sell an autonomous car at a predetermined price on a specified date, regardless of the actual price on that day.
Unveiling Options Trading
Options trading involves buying or selling options in the market. Traders can either create new options contracts or trade existing ones. Multiple buyers and sellers can engage in options trading within a predetermined period. The exchange keeps track of all changes, enabling final owners to have a comprehensive overview when the contract reaches its end.
It’s crucial to note that options trading comes with a specific price known as the premium. This price serves as a deposit, allowing potential buyers to secure their right to purchase at a predetermined price on or before the specified date. To validate the agreement, the buyer pays the premium, which acts as a down payment.
Let’s consider an example: You want to create a new options contract, predicting that the price of Google stock will exceed $3,000 per share within the next two years. Consequently, you wish to secure the right to buy these shares at $2,500 per share anytime during that period. Suppose you agree with another party, a seller who believes the share price will be lower, on a premium price of $10,000 for the contract. In that case, you need to pay the premium to make the agreement valid.
Importantly, options should not be confused with stocks. While options are derived from stocks, they do not represent ownership.
The Two Main Types of Options and Trading Strategies
Options come in two primary forms: call options and put options. A call option grants the holder the right to buy a share, while a put option gives the holder the right to sell a share. Both types of options fall under the category of derivative securities, as their value depends on the price of another underlying asset.
To better comprehend these concepts, let’s consider a real-life analogy. Imagine a building that is currently under construction. The final price of an apartment in this building, let’s say in two years, will depend on the real estate market prices in that particular area at that time.
Before we delve into call and put options, we need to introduce another term: the strike price. The strike price is a predetermined price agreed upon by both the buyer and the seller. For instance, suppose the strike price for an apartment in the aforementioned building under construction is set at $1,000 per square foot.
Now, let’s examine call and put options in this context:
- With call options, the buyer believes that the market price of an apartment will surpass $1,000 per square foot within the next two years, while the seller holds the opposite view. If the buyer’s prediction proves correct, they can buy the apartment at the strike price during the specified period and later sell it at the prevailing market price, thereby making a profit.
- On the other hand, with put options, the buyer speculates that the market price of an apartment will fall below $1,000 per square foot within the next two years. Conversely, the seller believes otherwise. If the buyer’s prediction comes true, they can purchase the apartment at the lower price and sell it to the option seller at the agreed-upon strike price, which is higher. In this case, the seller is obligated to buy the apartment at the strike price.
Combining the two types of options and their respective strategies, we arrive at the four fundamental ways to trade in the options market:
- Buying a call option
- Selling a call option
- Buying a put option
- Selling a put option
Both buyers and sellers of options seek to profit, albeit through different approaches.
It’s important to note that options are generally considered less risky than stocks due to their flexible withdrawal feature. However, they still carry a degree of risk due to their speculative nature.
Understanding Buy to Open and Buy to Close
The term “buy to open” refers to a trader purchasing a put or call option to initiate a new position. Conversely, “buy to close” indicates a trader selling a put or call option to exit an existing position.
In simpler terms:
- Buying to open entails creating a new options contract by purchasing a put or call option. This involves paying a premium to secure a position and obtain the right to take further action before the contract’s expiration date.
- Buying to close involves trading one’s portion of an already existing option. Initially, the trader received payment to create the option, but now they are paying someone else to assume their position until the contract expires.
When you buy to open, you are entering a new option contract and securing your position within it. Conversely, when you buy to close, you are removing yourself from an existing contract and closing out your position and associated risk.
Understanding Sell to Open and Sell to Close
On the other hand, “sell to open” pertains to an original buyer of the option selling a put or call option. Similarly, “sell to close” refers to the original buyer selling a call or put option to terminate a contract.
- Selling to open means selling an existing option that you already possess. You receive payment upfront, and the buyer assumes ownership of the option. However, your position within the contract remains open to fulfill its terms if the buyer exercises their rights before the expiration date.
- Selling to close involves selling the contract to another party. In this case, you previously bought the options and are now selling them to someone else, thereby disassociating yourself from the contract.
When you sell to open, you are trading an existing portion of shares that you previously bought, but you remain a part of the contract. In contrast, when you sell to close, you are selling your portion of shares and effectively closing the contract.
Real-Life Options Trading Scenarios
Options trading may initially seem abstract and challenging to understand. To provide a practical example and help you grasp the concepts of buying or selling to open (call options) and buying or selling to close (put options), let’s consider a real-life scenario.
Suppose you wish to purchase 10 stocks of Tesla. For simplicity, we will round the amounts to whole numbers. The current price of Tesla stocks in March 2021 is $600. Looking back six months, in September 2020, the price was $400. A year ago, in March 2020, it stood at $100. Expecting the price to rise, you believe it may reach $1,000 per share by March 31, 2022.
In summary, buying to open reflects a belief in future price increases, while the subsequent action is selling to close. Conversely, selling to open is based on a belief in price decreases, followed by buying to close.