Options are derivatives that are one step removed from the underlying security. Options are traded on stocks, exchange traded funds, indexes and commodity futures. One reason options are popular with traders is that they are less expensive to trade than the underlying security. Option traders have more choices when it comes to opening and closing a trade than security investors do. Buy to open and buy to close option transactions are designed to take advantage of upward and downward trends.
How Options Work
One option controls a fixed amount of the underlying security. For example, one option controls 100 shares of stock. You can trade two types of options -- calls and puts. A call gives you the right to buy the underlying security, while a put gives you the right to sell. However, unlike stocks, options are wasting assets. An option’s value decreases the closer it gets to the expiration date. Your risk depends partly on whether you’re buying the option or selling it. When you buy a call or put option, you limit your risk to the option’s purchase price and your broker fees.
Buy to Open Transactions
Use the buy to open transaction order when you want to purchase a call or put option. Buy to open lets you establish a long or short position in the underlying security. The option premium is immediately debited from your account. To profit, the underlying security price must either increase enough to push the call option price past the break-even point or fall enough to drive the put option price below the break-even point. To close out the trade, you must buy the call or put option back using a sell to close transaction order.
Buy to Close Transactions
The buy to close transaction order is used to close out an existing option trade. The trade was originally opened using a sell to open transaction order by which you sold a call or a put. This placed you in a short position regarding the underlying security. When you are ready to exit the trade, the buy to close transaction order closes out your short position. For a put trade to profit, the underlying security price must fall enough to drive the put option price below the break-even point. For a call trade to profit, the underlying security price must remain below the option’s sell to open price.
Buy to Close Risks
When you establish a short option position, you are credited with the option premium. The short position also makes you vulnerable to large losses should the trade move swiftly against you. As more the price of the underlying security continues to rise, the greater your loss will be. Should the underlying security’s price go upward and start a strong uptrend, it could cost you far more to buy the option back to close out the trade.
Video of the Day
- Ablestock.com/AbleStock.com/Getty Images