Buying to open is when you purchase a new options contract and assume either a long or short position. Conversely, buying to close is when you purchase an existing options contract that matches a contract you sold. In doing so you offset your existing contract and exit your position. Here’s a closer look at buying to open and buying to close.
The world of options trading is incredibly complex, so consider talking with a financial advisor about your strategy.
Options Contracts Basics
An options contract is a financial product known as a derivative, meaning that it takes (or “derives”) its value from some underlying asset. The owner of an options contract has the right to trade the contract’s underlying asset for a given price (strike price) on a given date (expiration date). This is a right, not an obligation. If the owner of an options contract doesn’t want to make the trade, they don’t have to.
There are two parties to every options contract: the holder and the writer. The holder of a contract is the party who bought it and has the right to exercise that contract’s option. The writer of a contract is the party who sold it and has the obligation to fulfill its terms if necessary.
Furthermore, there are two types of options: calls and puts.
What Is a Call Option?
For example, say that Richard holds an options contract that Kate wrote. It is a call option for XYZ Corp. stock at $15 with an expiration date of Aug. 1. On that date, Richard has the right to buy shares of XYZ Corp. from Kate for $15 per share. If, say, the price of XYZ Corp. shares has increased to $20, Kate will have to sell Richard those shares for $5 less than they’re worth.
What Is a Put Option?
For example, say that Richard holds an optionss contract that Kate wrote. It is a put option for XYZ Corp. stock at $15 with an expiration date of Aug. 1. This means that on Aug. 1, Richard has the right to sell shares of XYZ Corp. stock to Kate for $15 per share. If, say, XYZ Corp. shares have dropped to $10 per share, Kate will have to buy those shares from Richard for $5 more than they’re worth.
What Is Buying To Open?
Buying to open is when you enter a position by buying a new options contract. The writer creates a new contract and sells it to you for a set price, known as the premium, and you now have all the rights of that contract. Since this is a new position, it also creates a new market signal based on your particular bet for or against the underlying asset.
This can apply to both call and put contracts.
If you buy to open a call contract it means that you have bought a new call contract from the seller. This gives you the right to buy the underlying asset from the seller at the expiration date for the strike price. It signals to the market at large that you think the asset’s price will go up.
If you buy to open a put contract it means that you have bought a new put contract from the seller. This gives you the right to sell the underlying asset at the expiration date for the strike price. It signals to the market at large that you think the asset’s price will go down.
In both cases, you now own the options contract. This is called buying to open because it opens a position that did not exist before, making you the holder of a new contract.
What Is Buying To Close?
Buying to close is when a contract writer exits their position by buying an equal-and-opposite contract.
When you write and sell an options contract, you’re entering a new position. In exchange for an up-front payment, called the premium, you assume the responsibilities of this contract. In a call contract, this means that you have to sell someone the underlying assets if they choose to exercise their option. In a put contract, you have to buy the assets if they exercise their option.
This is good in that you get paid for taking that risk, but it’s still a risk. If the asset price doesn’t move the way you expected you can be on the hook for those losses.
For example, say that you sell Martha a call contract for XYZ Corp. stock. The expiration date is Aug. 1 and the strike price is $50. If Martha chooses to exercise her contract, then on Aug. 1 you must sell shares of XYZ Corp. stock to her for $50 per share. If, say, XYZ Corp. stock is selling for $60 per share at the time, you would lose $10 per share on that contract.
To eliminate that risk you can exit your position by buying a new contract identical to the one you sold.
In our example above, you would go to the market at large and buy a call contract for XYZ Corp. stock with an Aug. 1 expiration date and a strike price of $50 per share. You now hold offsetting positions. For every $1 you may potentially owe Martha, the contract you hold will pay you $1. For every $1 you can make off the contract you hold, you will owe Martha $1. The contracts cancel each other out, leaving you with a net-zero position.
Buying the new contract will cost you a premium, which will most likely be more expensive than the premium you collected for selling the first contract, but you will have exited the position.
Role of the Market Maker
To understand why this works, it’s important to remember the role of a market maker.
Every major market goes through what’s known as a “clearing house.” This is a third party that takes in all transactions, equalizes them and then makes all collections and payments as necessary. With options, this means that everyone buys and sells their contracts to and through this market.
For example, Richard might buy a contract that Kate wrote, but he buys that contract from the market. If he exercises his option, he collects his money from the market at large, not from Kate directly. The opposite also holds true. Kate might write a contract that Richard holds, but she sells that contract to the market. If she owes money on it, she pays that money to the market.
The result is that all debts and credits are calculated against the market at large. Kate doesn’t owe Richard $500, say. She owes $500 to the market, which in turn pays Richard the $500 that his contract is worth.
This is what makes buying to close work. When you write an options contract, you hold this position against the market at large. When you buy a new, offsetting position, you buy that from the market at large, as well. Regardless of who holds the contract that you wrote, the market maker will pay and collect everyone’s money equally. The result is that for every $1 you owe to the market, the market will owe you $1 and you will end up owing and collecting nothing.
Buying to open is when you buy a new options contract and enter a new position. Buying to close is when you buy an options contract that offsets a contract that you wrote, allowing you to exit your position. Also, keep in mind that all profitable options trading results in short-term capital gains.
Tips on Investing
- Options can be a speculative, but potentially profitable, section of the market. A financial advisor can help you determine whether options trading is right for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re going to be trading options, it’s important to understand how these derivatives are taxed. Be sure to give our options taxation guide a read before diving into these transactions so you’ll know the tax implications going in.
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