[Trade Options]:What Do “Buy To Close,” “Buy To Open,” Mean?
Options are generally seen as one of the most straightforward investments in the forex market. They rarely get complicated as they only have four different strategies. The only time they can get complicated however is if you decide to add multiple options contracts together. Doing that is known as multi legged positions.
What exactly are these option investment strategies and how do you go about it? In this article, we're going to take a deep dive into options and how to safely invest in them. It's important to be careful when dealing with options. This is because failure to do so may cause you to lose all your money and even more. Don't let this risk deter you anyways, once you read this and you decide to do other deep research into options before investing in them, you won't have that much of a problem with them.
Four Basic Option Trades
An options contract is the type of contract in which you have the "option" to sell or buy underlying securities. Call options are when you have the right to buy underlying shares while put options on the other hand involve the right to sell those shares.
Other important aspects of options contracts include the strike price, the premium fee, and the values that determine the validity of the option. (Time value, intrinsic value, and volatility). Options generally don't have as much liquidity as stocks so it's advised to use a stop order when dealing with them. With these being said, let's discuss the four basic options trades. Some charts have also been provided alongside the strategies to give a much better explanation. These charts would analyze the potential profits at the expiration date of each explained position. They all assume an option contract of 100 shares with the premium price being $3 per share and a strike price of $50
Buying a Call Option
This is also referred to as the long call position. It's when you pay for the rights to buy shares of the stock of a particular company. Buying of shares is usually done before a certain date and is bought at a particular price. When you buy and hold shares of a company like that, it's because you probably have an intuition that the company's stock would rise, which would mean more profits to you. If you buy and hold shares of a company's stock and it rises while you were holding it, it means your profit over the shares you bought would increase along with it. You would earn more than just owning the said stock. This is considered a bullish strategy (buy at a low price, sell at a high price)
On the other hand, if the company stock falls, before its expiration date, you would lose all your investments on said shares. One thing you need to know about this strategy is that time comes at a disadvantage. The option may expire while at-the-money (barely any profit due to strike price being at the same price as the option itself) or in-the-money (strike price is slightly lower than an option)
This strategy is mostly used to hold a short position on the underlying securities.
Selling a Call Option
This is also called the short call position. This is when you get paid to pick up shares of a company's stock and sell them. In this instance, you would make a profit if the company's stock drops instead of rises. This is known as a bearish strategy (buy at a high price and sell at a low price) as your main profit is in the premium fee.
Now, if you purchase said stocks with a sell option order and the price of the stock goes low or doesn't move from its position at all, you can get 100% of the premium price as your profit.
Now, on the other hand, if the stock rises, you could face an irrecoverable loss. Time in this instance is an advantage. You just have to make sure the stock doesn't rise before the expiration date so you can maximize your profits. You would also be able to profit from the trend of the stock making a sideways movement instead of a downwards movement.
Buying a Put Option
This is known as the long put position. It's a kind of security or insurance policy for investors. In this case, you can only profit if the trend of the stock goes either sideways or downwards. Now, as regards the insurance policy, investors purchase puts so that if their puts rise at the same time that their stocks fall or vice versa, they won't lose that much of their investments, I.e their portfolio would remain flat overall (or close to it).
From here, it can be seen that this position is the exact opposite of the long call position ( when you buy a call option). It uses a bearish strategy too (sell at a high price, buy back at a low price).
Selling a put option
Also called the short put position, it involves you getting paid to buy shares this time, instead of selling them. In this case, you can profit from the option if the strike price remains the same or increases before the expiration date. It's important to note here that if the stock falls instead, your losses would be limited as you won't lose all your investments unlike you would if it was a short call position (when you sell a call option). This is because the strike prices don't generally drop below $0
How Options Work
To properly illustrate, let's come in with an example. When you see a look at a basic option, you may see something like this;
XC June 75 Put $4.75
XC is the symbol of the company that owns the stock. It's the main stock itself that's involved in the options contract
June is the month the option expires.
75 in this instance is the strike price. It's the amount you can buy the underlying security for.
Put shows that this is a call option rather than a call option. It helps differentiate between both
$4.75 is the premium price you have to pay per share. Let's say the option is a standard of 100 shares you'll pay $475 upfront as the premium fee. The fee is non-refundable.
Buy To Open Vs Buy To Close: What's The Difference
This section would explain what you need to know about entering or exiting an options contract. There are generally four ways to go about the options contracts. They are; buy to open, buy to close, sell to open, and sell to close. However, we're only looking at the first two.
Buy To Open
When an investor or a trader is executing a buy to open contract, it means they want to create a new options contract. This position can be used to buy both puts and calls and there's no difference in how it works for both. Assuming this position generally means the trader is going long, hence, the premium is directly debited from the trader's account.
When a buy to open contract is used for a call option, it means the trader believes or is hoping the stock would rise which would inadvertently give value to it. Ok the other hand, if the buy to open contract is used on a call option, it means the trader is hoping the stock falls or stays stagnant. In this instance, it's not about the underlying stock, it's about the option itself.
Buy To Close
Whenever a call or put option is sold, the trader or investor is put in a short position. This gives them some money that allowed them to create said option. The money in this case is the premium. After a while and the position moves into a position that makes the trader either gain or lose, the trader may want to close their position before expiration. To do that, they buy back the options they sold in the first instance, and doing that would require them to make a buy to close order.
The difference between a buy to open and a buy to close order is that in a buy to close option, the trader is trading in a previously created position.
The second difference is that the trader is seeking to close their position in a buy-to-close contract.
There you have it. All you need to know about options is how to trade in any of the highlighted positions. So go ahead, make that investment and trade safe.