When trading options, there are four different basic ways to place an open order or a close order.
Buy to Open (BTO) is one of the two types of options orders that can be used in options trading to open a position. The other type of order is Sell to Open (STO).
Buy to Open refers to the beginning of a long position, either a call or a put option. Any option contract (call or put) that you have bought is considered a long option position.
This is a rather simple concept, comparable to normal stock trading, in which you create a position by purchasing a certain number of stock shares.
What is an Option?
There are only two main types of options: calls and puts.
A call option contract is an agreement in which an option buyer (holder of the call long option) gets the right (but not the obligation) to buy the shares of the underlying stock at a set price within a certain expiration date.
The call option seller (the option trader doing call writing) assumes the short position, getting an option premium.
If assigned, the seller of the option, will have to sell the shares of the underlying security to the option buyer at the specified price (also known as strike price or exercise price) even if the price of the underlying asset is lower than the current market price.
On the other hand, a put option contract is an agreement in which an option buyer (holder of the put long option) obtains the right (but not the obligation) to sell the shares of the underlying stock at an agreed price within a certain expiry date.
The put option seller (the stock market participant on the other side of the option contract) takes the short position, receiving an option premium.
In case of assignment, the put seller, will have to buy the shares of the underlying security from the option buyer at the specified price (strike price) even if that is higher than the share price on the open market.
Buy to Open a Long Call
Assume you believe a stock will rise sharply in the near future. As a result, you decide to purchase a long call in order to profit on the move.
To do so, you create a new position by buying to open a long call with a predetermined expiration date and strike price.
That position will remain open until one of three things occurs:
- at the expiration date, the stock price is below the strike price, and the call option contract loses any time value, expiring worthless;
- at the expiration date, the stock price is above the strike price, and you exercise the option contract by acquiring 100 shares of the stock or ETF (for any option contract you bought) at the predetermined price;
- any time before expiration, you close the open long call position by selling back the option contract (this type of trading order is called Sell to Close).
Buy to Open a Long Call – Example
Stock ABC is currently trading at $50 per share, and you anticipate it will make a significant move to the upside in the coming weeks. As a result, you buy to open a long call option with a strike price of $60 expiring in 45 days, paying a premium of $0.50 per share ($50 for each option contract excluding commissions).
Because the stock price is trading below the strike price when you buy to open the position, the option price is entirely made up of time value (extrinsic value), while the intrinsic value is equal to zero. The long call option is referred to as being out-of-the-money (OTM).
First Possible Alternative
The stock is trading at any price below the strike price on the expiration date. In this situation, the call option expires worthless, and you will loses the whole premium paid to start the option contract. As expiration approaches, all of the extrinsic value included inside the option price decreases until it reaches zero due to the time decay effect.
Second Possible Alternative
At expiry, the stock is trading at a price higher than the strike price, making it in-the-money (ITM). In this case, too, any time value in the option price is zero. The intrinsic value, on the other hand, is positive, and it is calculated by subtracting the strike price from the stock price on the expiration date.
For example, if the stock is currently trading at $70, the option price at expiration would be $70 (stock price) minus $60 (strike price), which equals $10. After deducting the $0.50 premium per share paid to initiate the position, you have a net profit of $9.50 per share, or $950 per contract (excluding brokerage commissions).
In this instance, you have the option of letting the option expire and being assigned. This means that you will purchase 100 shares of ABC stock (for every options contract you possess) at a strike price of $60, even though the stock is currently trading at $70 per share on the open market.
As an alternative, you can decide to sell to close the long call position for a profit just before expiration at a price close to $10 per share. At that time, the option price will be mainly determined by the intrinsic value, as the extrinsic (time value) will be close to zero.
Third Possible Alternative
You can sell to close the long call option contract at any point before expiration, regardless of whether the stock price is trading below or above the option strike price.
Of course, if the stock price is lower of when you opened the position, the option price has most likely decreased. This is related to the time decay effect, which erodes an option’s extrinsic value with the passage of time.
On the other hand, if the stock price has risen since your entry price, the option price may have risen as well, allowing you to close the position for a profit. In any case, other factors, such as the change in the implied volatility (IV) in the option contract for that specific expiration, may have an impact on the overall option price.
Buy to Open a Long Put
Assume you believe a stock will decline significantly in a short period of time. As a result, you decide to buy a long put to profit from the move.
To do so, you establish a new position by buying to open a long put with a fixed expiration date and strike price.
The position will remain open until one of three things occurs:
- at the expiration date, the stock price is above the strike price, and the put option contract loses any time value, expiring worthless;
- at the expiration date, the stock price is below the strike price, and you exercise the put option contract (only if you already owned the underlying shares and purchased the put as a way to protect the stock position) by selling the shares of the stock or ETF at the agreed upon strike price;
- any time before expiration, you close the open long put position by selling back the option contract (this type of trading order is called Sell to Close).
Buy to Open a Long Put – Example
Stock XYZ is currently trading at $100 per share, and you anticipate it will make a significant move to the downside in the coming weeks. As a result, you buy to open a long put option with a strike price of $90 expiring in 45 days, paying a premium of $1.00 per share ($100 for each option contract excluding commissions).
Because the stock price is trading above the strike price when you buy to open the position, the option price is entirely made up of time value (extrinsic value), while the intrinsic value is equal to zero. The put call option is referred to as being out-of-the-money (OTM).
First Possible Alternative
The stock is trading at any price above the strike price on the expiration date. In this situation, the call option expires worthless, and you will loses the whole premium paid to start the option contract. As expiration approaches, all of the extrinsic value included inside the option price decreases until it reaches zero due to the time decay effect.
Second Possible Alternative
At expiry, the stock is trading at a price lower than the strike price, making it in-the-money (ITM). In this case, too, any time value in the option price is zero. The intrinsic value, on the other hand, is positive, and it is calculated by subtracting the stock price from the strike price on the expiration date.
For example, if the stock is currently trading at $80, the option price at expiration would be $90 (strike price) minus $80 (stock price), which equals $10. After deducting the $1.00 premium per share paid to initiate the position, you have a net profit of $9.00 per share, or $900 per contract (excluding brokerage commissions).
In case you own 100 shares of stock XYZ, you have the option of letting the option expire and being exercised. This means that you will sell the 100 shares of the stock you possess at the strike price of $90, even though the stock is currently trading at $80 per share on the open market.
As an alternative, you can decide to sell to close the long put position for a profit just before expiration at a price close to $10 per share. At that time, the option price will be mainly determined by the intrinsic value, as the extrinsic (time value) will be close to zero.
Third Possible Alternative
You can sell to close the long put option contract at any point before expiration, regardless of whether the stock price is trading below or above the option strike price.
Of course, if the stock price is higher of when you opened the position, the option price has most likely decreased. This is related to the time decay effect, which erodes an option’s extrinsic value with the passage of time.
On the other hand, if the stock price has fallen since your entry price, the option price may have risen, allowing you to close the position for a profit. In any case remember that other factors, such as the change in the implied volatility (IV) in the option contract for that specific expiration, may have an impact on the overall option price.