Buy To Open Vs. Buy to Close: How Does It Work?

Article Summary:

“Buy to open” and “buy to close” are terms used in the creating, buying, and selling of securities, like stocks and options contracts. However, they are most commonly used in options, which we focus on here. An investor who buys to open is effectively opening a new position on an options contract hoping the options contract increases in value. In contrast, buying to close means buying out a net short position of an existing options contract, in which the trading thesis was that the option would decline in value.

Every day, trillions of dollars move through the financial markets, with investors and financial institutions making bets on stocks or securities moving up and down in price. Most people in the retail investment world directly buy and sell assets like stocks with the idea of buying long or shorting the stock or asset. This is also known as having a long or short position. Going long implies that the asset you bought will increase in value over time. On the contrary, going short is a strategy of hoping that the asset declines in price over time. This is a pretty simple way for most people to make a profit.

The options market revolves around options contracts, which are derivatives of underlying assets like stocks and can work in the same manner as their underlying assets, with some important differences. Learn more about these contracts below.

Buy to open vs. buy to close

If a trader is buying to open, they are creating a new options position using either call options or put options. Just like when an investor goes long on a stock and hopes that it increases in value, they hope that the value of the option increases in value over time. In contrast, buying to close represents the selling of an options contract to close out someone’s short position that already existed.

There are two important concepts to note here. Although they both use the term “buy,” one is opening a position and the second is closing a position. Also note that they are both going long and going short on the option, not the underlying stock or asset that the options contract is linked to. Depending on whether the option was a call or a put option, the time frame, the state, and the trajectory of the market will determine if the option can increase or decrease in value over time.

Options 101

Options are contracts between two parties that give the buyer of the option the right, but not the obligation, to buy a stock or underlying asset for a certain price. The buyer has the right to either buy or sell the underlying asset like a stock but is under no obligation to do so. The buyer of the option will be charged what is called an “option premium” for the right to buy or sell the stock for a certain price. Here are some terms you should probably know in the trading of options.

Strike price

This is the agreed-upon price that is represented in the options contract. In the context of call options, it’s the price that you have the right to still buy a stock at, regardless if it goes up. In the context of put options, it’s the price that you have the right to sell a stock at, regardless of if the price has gone down.

Time frame

Every options contract has an agreed-upon time frame. In the context of call options, it’s the time frame when you are still allowed to buy the stock at the agreed-upon strike price. If it’s a put option, it’s the time frame in which you are allowed to sell the underlying asset at the agreed-upon strike price.

Options can also suffer something called “time decay,” which hurts an option’s value. Time decay measures the rate of decline of an options contract strictly due to the passage of time. The more time passes, the less time you have to exercise the option, having a negative effect on the option’s value. Time decay will continue to accelerate the closer an options contract is to its expiration date or maturity date.

Option premium

The option premium is the price that the buyer of the option pays to the option seller to exercise this option. If you want to have the right to buy or sell a stock at a certain price, you pay the writer of the option an amount of money upfront.

If you prefer this style of investing, you may want to consider opening an account with one of the brokerages below, all of which deal in options.

Call options vs. put options

Call options

A call option is a contract between two parties in which the buyer has the “right” to buy stocks for a certain price for a certain period of time. They have the right to buy the stock for this price but are not obligated to do so. With call options trading, you feel the value of the stock is going to increase over time. For the right to buy the stock, they will pay the requisite option premium. For example, if a stock is listed at $20 per share, but you feel, based on its price direction, that it will increase to $30, you would pay an option premium of $2 to have the right to continue to buy this share for $20 (strike price) during the agreed upon time frame.

Put options

Put options are contracts between two parties in which the buyer has the “right” to sell stocks for a certain price over a period of time. With put options, you feel that the value of the stock is going to decrease over time. For example, if a stock is listed at $20 per share, but you feel it’s going to decline to $10 (strike price) over time, you would pay an option premium of $3 a share. You then have the right to continue to sell this option for $20 a share, even if the price declines significantly to $10.

Buying to open

When you buy to open, you create an entirely new option. You are buying to open a new position on something by creating and/or buying a new options contract. Buying to open means that you are going to take a “long” position on this option, indicating that you feel the value of the option can increase. Remember, it’s the option we are talking about, not the underlying asset that the options contract deals with. No matter if the option is betting on a decline in the value of the stock with a put option or an increase in the value of the stock with a call option, the state of the market and how the option is constructed with its time frame will determine how much the value of the option moves up and down.

Let’s use an example of Wheat of the World WOW stock from our article on call options. In this case, we think the price of wheat is going to increase over time. Here is how we break it down.

WOW list price = $20

Call option strike price = $20

WOW call option time frame = 3 months

WOW option premium = $2

Let’s say you bought 500 call options of WOW for $1,000 in total. You pay a $2 option premium per share. Now let’s say that the price does indeed double to $40 per share in two months. Because your call option contract’s time frame is for three months, you can buy it for the $20 agreed-upon stock price, plus the options premium. The ROI breakdown works as below.

WOW new list price = $40

Call option strike price = $20

Wow option premium = $2

Option ROI = (40-20) “difference in list vs. strike” / $22 “strike + premium”

WOW option ROI = 90.9%

In this case, you BUY to OPEN a call position through an options contract. The result is the creation of a new options contract, and you are buying the contract to open a position on WOW. If, after a period of time, you decide to sell that options contract, then you will sell to close. You will SELL that contract to another person to CLOSE your position. Remember, if you bet that a stock will increase with a call option and it does, the value of the option will also increase. Likewise, if you bet that a stock will decrease with a put option and it does decrease, the value of the option will also increase.

Buying to close

With a buy to close, you exit out of an existing short position on an options contract that was already created. A buy to close is the exiting out of a net short position, meaning that you had bet that the value of the option will fall. To establish a short position on an option, you would sell to open. A SELL to OPEN trade is the establishment of open short positions on options.

It’s important to understand here how shorting stocks and shorting options behave both similarly and differently. In the case of shorting stocks, you borrow the stocks from another entity with the hope of repaying that stock by buying it back on the open market for a lower price. When you buy back the stocks for a lower price on the open market, you are buying to cover. You buy the stocks back at a lower price so that you can pay back the stock lender, also known as covering the stocks that you borrowed. You pocket the difference between the price at which you borrowed the stocks and the price at which you bought them back.

Just as you buy to cover when you directly short stocks, you buy to close when you exit your net short position in an option with the hope of getting a profit. However, on an options contract, you do not borrow anything from anyone. On an options contract, you take the seller’s side and buyer’s side simultaneously in the position to deliver on the promise of the performance of the stock or underlying asset.

But what am I buying and how does it close?

When you created your net short position on an option, you would have sold to open, which creates your net short position. That is when the option was created — when you sold to open. After a period of time, you then buy back the option that was created. Remember, unlike shares that you borrow and cover, in buying back an option you shorted, you take both sides of the contract. So now, you are both the writer and beneficiary of the option; you represent both parties. Effectively, you and yourself cancel each other out, and the option disappears. This is why you buy to close. You are buying the option contract back, and now you represent both parties in the contract. This allows the option to effectively evaporate into thin air, and your position is now closed.

How do I make money on a buy to close?

You make money on a buy to close through the option premium that was charged when the contract was written. That is, as long as the option premium is higher than the agreement regarding the obligations under the contract.

We can break this down again, using the example of the WOW call option. But in this scenario, you shorted the value of the WOW call option rather than just simply opening a WOW call option.

WOW original list price: $20

New list price: $20.25

WOW option strike price: $20

Original option premium = $2

New WOW option premium = $0.50

Original premium ($2 net credit) – new option premium ($.50 net debit ) = $1.50 profit per share

The premium on the WOW option is now significantly lesser than the obligations to honor the strike price. This is where the money is made. The option premium will have declined significantly in value. This is for two reasons. One is that the current list price of the underlying asset is way under the agreed-upon strike price, leading the option to decline in value. The second is because of time decay, as mentioned above, leading to the option to decrease in value over time naturally. When you create the net short position by creating the options contract, you receive the option premium or net credit upfront. You then buy back the option for a significantly lower options premium than you received when you created it.

You pocket this difference. If, for instance, the value of the option premium is $.50 when you buy it back, you would have made ($2 net credit – $.50) = $1.50 per share profit on net credit – net debit.

More investment options

Learn more about ways to invest your money and advisors that can point you in the right direction with our Investment Guide. You can also read reviews of advisors before you jump in.

FAQ

What is a buy to close example?

You bought a call option for WOW stock listed at $20, with a strike price of $40 and a premium of $2. The stock only increases to $20.25 and the option is only worth $.50. You buy it back and then pocket the difference between the original option price (option premium) and the new value.

When should you sell to close an option?

When you want to close an existing long position on an option.

Do you buy or sell to open a put?

Opening a long put position requires you to “buy to open” the put. In other words, you would have to buy the put. For example, let’s say you want to set a protective put. You are banking on prices moving higher, but you buy a put as a form of insurance in case the stocks fall. If the market falls, the put will increase in value and offset your losses.

What happens when you buy to open a put option?

You feel that the underlying asset is going to decline in value, and so you open a put to take a long position that the asset will decline in value.

Key takeaways

  • Buying and selling options work both similarly and differently to buying and selling stocks.
  • Buy to open is when you feel the underlying security will increase or decrease in price, so you open up a long position via an options contract. Buying to close is when you exit an existing short position.
  • When you short a stock, you borrow stocks and then pay them back by buying at a lower price and then paying them back. When you short an option and buy it back, you now represent both parties in the contract.
  • Money made on shorting options with a buy to close is made on the option premium, which benefits from time decay, in a short trading thesis.
View Article Sources
  1. Options Trading – SEC
  2. Options – Investor.gov
  3. What Happens When a Call Option Expires? – SuperMoney