What it means
Every options order is labelled as either opening or closing. An opening transaction starts a position, such as buying a call option to bet on a rising price, or writing a put option to collect premium.
A closing transaction does the opposite and ends a position that already exists. The label matters for record keeping and for margin.
Brokers need to know whether a sale is closing an option the customer owns or opening a new obligation as a seller, because writing an option carries potential losses and requires collateral. Exchanges also use the labels to count open interest, which is the total number of contracts still outstanding.
The four common instructions are buy to open, sell to open, buy to close and sell to close. Buy to open creates a long position that has limited risk, which is the premium paid.
Sell to open, also called writing an option, creates a short position in which the seller receives the premium but accepts the obligation to deliver or buy if the option is exercised. The cash effect differs by direction.
A buyer pays the premium straight away and can lose no more than that amount. A seller receives the premium but may face large losses and must therefore post margin, which is cash or securities held as security with the broker.
Closing out later is the natural counterpart. A buyer who opened a position can sell the same contract to close it before expiry and lock in whatever value remains, while a seller can buy the contract back.
If neither happens, the option expires or is exercised according to its terms. For finance teams using options to hedge, the distinction is important in accounting and controls.
The opening transaction fixes the date, premium and strike price that determine how the derivative is measured at each reporting date. Mislabelling a trade can cause errors in position reports and in margin calculations.
In practice
Real-world examples.
Example
An airline treasurer buys call options on oil to protect against rising fuel prices. The purchase is a buy-to-open transaction, and the premium is recorded as a derivative asset on the balance sheet. The maximum loss is the premium paid, and the treasurer reports it to the board as the cost of protection.
Example
An investor owns shares and sells call options against them to earn extra income. The sale is a sell-to-open transaction, and the broker credits the premium to her account. She keeps the shares as cover for the obligation.
Example
A fund manager who thinks a market will fall buys put options to open a protective position. The cost of the premium is treated as the price of insurance for the portfolio. If the market rises instead, the options expire worthless and only the premium is lost.
Formula
Calculation
Premium cost of a buy-to-open trade = number of contracts x contract size x premium per share
A trader buys 5 call option contracts to open, with each contract covering a standard 100 shares and a premium of $2.40 per share. The premium cost = 5 x 100 x 2.40 = $1,200. That amount is the most the buyer can lose on the position, and it is paid on the day of the trade. The same trade would be a sell-to-open if the trader were writing the options, in which case she would receive the $1,200 and take on the obligation instead.Case study
Seen in the real world.
Granite Harbour Farms is a fictional agricultural company that expected to sell grain later in the year. The finance director wanted protection against a fall in prices and decided to buy put options.
The purchase was a buy-to-open transaction for 20 contracts at a premium of $1.50 per unit, with each contract covering 5,000 units. The total premium was 20 x 5,000 x 1.50 = $150,000, which the company recorded as a cost of the hedge.
In this illustrative story prices fell during the season, the puts gained value and offset part of the lower sale price. The finance team reported the hedge result next to the physical sales, and the board saw that the opening transaction had worked as insurance. The premium of $150,000 was, in effect, the price of certainty about a minimum selling price.
Watch out
Common mistakes.
- Labelling an order as opening when it should close an existing position, which can accidentally create a new obligation.
- Thinking a sell-to-open trade is risk free because the seller receives cash up front, when the potential loss can be large.
- Ignoring margin requirements on sold options, which may require extra cash if the market moves against the seller.
Questions
People also ask.
What does buy to open mean?
It means buying an options contract to start a new long position, as opposed to buying one back to end a short position.
What is the difference between opening and closing transactions?
An opening transaction creates or increases a position, while a closing transaction reduces or eliminates one.
Can an opening transaction be a sale?
Yes, selling to open means writing an option, which creates a short position with an obligation.
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