Buy to Open vs Buy to Close
Options are one of the most popular derivative instruments. Like many other instruments, options came to the cryptocurrency market from traditional finance. This is a versatile tool, that is great for making money on any price changes, as well as for reducing and hedging risks.
At the same time, options trading is quite complicated, especially for novice traders. Below, we describe the basic concepts of options in a way comprehensible even for beginners.
Key Takeaways
- Buy to open is used to open a long position
- When a seller is closing their short position, they use buy to close
- The position established with buy to open is closed by the buyer with sell to close
- Buy to close is used to exit a position opened by a seller with sell to open
What Are Options?
An option is a contract that gives its holders the right (but not the obligation) to buy or sell the underlying asset at a set price on a certain date.
The distinguishing characteristic of options contracts is their asymmetry. That is, the buyer of an option has no obligation to buy or sell the underlying asset, while the seller has an obligation to sell or buy it at a set price. Therefore, in the event of an unfavorable movement of the price of the underlying asset, the buyer can opt not to execute the contract.
On the other hand, the seller (also called the option writer) is obliged to deliver the underlying asset if the buyer decides to exercise the option. For that obligation, the option buyer pays a premium at the moment of the option purchase to cover the seller's risks.
Two Main Types of Options and How to Trade Them
There are two basic types of options — a call option and a put option. A call option gives the buyer the right to purchase an asset, and a put option — to sell an asset at an agreed price (strike price) before the expiration date.
A put option is a bearish strategy, which makes them similar to short selling. However, an importance difference is that put options can be used as insurance for the investor's holdings. For example, if the price of BTC falls, the put option holder can sell BTC at a higher strike price. But if the price rises, the loss on the deal will be equal to the premium paid.
One of the main reasons for the complexity of options are the abundance of special terms that are not used in other types of crypto trading. Understanding of these terms is essential for successful options trading:
- Expiration date — the time the option expires;
- Strike price — the target price at which you will be able to buy or sell cryptocurrency. Depending on whether the asset price reaches this mark, the seller of the option will (or will not) deliver the asset;
- Premium — the amount paid to the seller at the time of the option purchase;
- Intrinsic Value — the difference between the strike price of an option and the current market price of its underlying asset. It allows you to determine the profitability of the option;
- In the money — an option with a positive intrinsic value;
- Out of the money — an option, the intrinsic value of which is equal to zero (because the intrinsic value can not be negative). In other words, such option will not bring any income if exercised.
Now, as we looked at the main terms, let’s move to the options trading process. First, the seller of the option places the contract on the cryptocurrency exchange, specifying the price and expiration date. To ensure the fair value of the option (premium), various parameters are used to estimate it, including time to expiration, market price and volatility of the underlying asset.
Next, the option buyer finds an order in the market that matches their requirements. Buying an option does not involve the use of leverage or borrowed funds. Option buyer must have sufficient funds to execute the deal, and option seller must deposit funds as collateral.
Most often, options are American-style, which means you close the position whenever you want — on the expiration day or any time before it. You exercise the option by executing a spot order to sell your option, or simply by executing the option early.
Trading Call Options
Let's have a look at the example of buying a Call option.
For instance, Bitcoin is worth $20,000. The trader expects that the price will rise, wants to buy 1 BTC, but does not have enough money right now. Yet, they can afford an option, the premium of which is worth only $1,000. Therefore, he or she purchases an option contract with the right to buy 1 BTC at $20,000.
If BTC goes up to $25,000, the buyer can exercise the right to buy BTC for $20,000 from the seller and gain on reselling the asset immediately. In this case, the buyer’s profit will be $25,000 – $20,000 – $1,000 = $4,000.
In a negative scenario, if the price of BTC falls to $15,000, the option buyer will not choose to exercise the option. It will be more advantageous to buy BTC from the market. The buyer's loss will be equal to the premium — $1,000.
Trading Put Options
The procedure of buying a Put option is simply a reversal of buying a Call option.
Suppose Bitcoin is worth $20,000. The trader expects Bitcoin to fall in price. They purchase an option contract with the right to sell 1 BTC at $20,000. The premium for the option will be the same — $1,000.
If BTC goes down, for example, to $15,000, the option holder can exercise the right to sell BTC at $20,000. In this example the profit of the option buyer would be $20,000 – $15,000 – $1,000 = $4,000.
In the opposite situation, if the price of BTC rises to $25,000, the option buyer will not exercise the option because it would be more profitable to sell BTC in the market. The loss will be equal to the premium — $1,000.
Buy to Open and Buy to Close in Crypto Options
While trading options on Bitcoin or Ethereum, as well as other cryptocurrencies, a trader can act either as an option buyer or as an option seller (or writer). An option buyer opens a long position (call or put), while an option seller opens a short position (long or put). In each case, they will also have to close the deal. Thus, there are four types of deals in total:
- Buy to Open — purchasing an option contract to open a trade;
- Buy to Close — purchasing an option contract in order to close a trade;
- Sell to Open — selling an option contract (or writing a contract) to open a trade;
- Sell to Close — selling (or writing) an option contract to close a trade;
To explain better these types of deals, and buy to close vs buy to open in particular, we will provide possible scenarios for each type.
What Is Buy to Open?
“Buy to open” means purchasing an option in order to open a long position. It refers to the establishment of a position by a buyer. No matter if you are buying a call or a put option, in either case you will be buying to open.
Let's say you want to buy 1 BTC. The price of BTC in February 2023 is $20,000. You assume that the price will rise in the future, and you believe that it can reach $25,000 in March 2023 (or earlier). Therefore, you buy to open a call option contract, with the right in March 2023 to buy BTC at a strike price of $20,000.
What Is Buy to Close?
“Buy to close” refers to purchasing an option to close out an existing short position on a put or a call option. Essentially, it means that an option seller wants to buy the same option contract in order to exit the position on a previously sold contract.
Let's say you want to sell an option and to receive a $1000 premium for it. The price of BTC in February 2023 is $20,000, and you assume that the price will fall in the future down to $15,000 in March 2022 (or sooner).
With that in mind, you sell a call option with a $22,000 strike for a $1000 premium. Thus, you took a short position on the underlying asset. If the price of BTC goes down, the option will not be exercised upon expiration. Eventually, your profit will be equal to the entire premium received back when you sold the option.
However, if the BTC price does not fall, or on the contrary, shows a rise, it creates a theoretically unlimited risk for the call option writer. In this case, you will need to have to buy to close to avoid the even greater losses you may incur by waiting longer. In order to close the existing short position, you will need to purchase the same contract.
Buy to Open vs. Buy to Close: Explained
At the first glance, buy to open and buy to close orders seem to be similar, as both are used to purchase option contracts. However, there is a crucial difference between buy to open and buy to close orders. The former refers to opening a long position, and the latter — to closing a short position.
Another important difference is that these two orders are performed by different sides of the trade. Buy to close order is used by the seller/writer of the option with the purpose to close out a position they have opened before. Buy to open order is used by the buyer of the option, who buys an option to open a trade.
Sell to Open vs. Sell to Close: Explained
Unlike buy to open and buy to close, sell to open and sell to close are used in exactly opposite scenarios.
The sell to open order means to open a short position by selling (writing) an option contract. This transaction allows the seller of the option to receive the premium paid by the buyer.
Sell to close means to sell a call/put option to lock in profits on this option contract you own. This type of order closes a long call or long put option. Sell to close means to give up the ownership of the option and no longer benefit from further price movement (if any).
When to Use Each
Now that we discussed the difference between buy to open and buy to close, let’s summarize when to use these orders.
First, you need to decide which side of the trade to take. Remember that a seller’s losses are potentially unlimited, while a buyer’s losses a limited by the amount of premium paid. Another important thing to consider is that it might be harder to find a cryptocurrency platform which offers taking a seller’s side.
Whenever you want to buy a put/call option to gain on the upward/downward price movement, you should buy to open. Taking a buy to open position might also be useful in hedging against a potential price drop. Essentially, you are opening a long position with a buy to open. This order can be closed later for a profit or loss by using a “sell to close”.
In case you take the seller’s side, sell to open if you believe the underlying asset will not move beyond the strike price. In other words, you are opening a short position in a hope that the price will not go into the buyer’s desired direction. Thus, you will benefit from the paid premium and will not have to deliver the asset.
The opened short position can be closed with a buy to close order. As a seller, use this order when you have achieved the desired profit or want to avoid the risk of a loss.
4 Scenarios of How to Trade Crypto Options
All in all, there are four basic scenarios to trade options on cryptocurrencies: either open and close a long position, or open and close a short position. Let’s take a closer look at each of the possible scenarios on the example of Bitcoin.
Scenario 1: Opening a Long Position
If you believe that the price of Bitcoin is going to increase or decrease, you can open a long call or put position, respectively. In this scenario, you should use buy to open to buy the option contract.
Scenario 2: Closing a Long Position
Suppose the Bitcoin price has moved into the favorable direction, and you want to lock in profits from your opened long position. You should use sell to close, effectively closing out your position.
Scenario 3: Opening a Short Position
If you are an option seller, you are taking the opposite side of the trade by opening a short position. That is, if you bet that the price of Bitcoin is going to increase, you should sell a put option. And vice versa, if you bet the price will decrease — sell a call option. In this scenario, you would use sell to open.
Scenario 4: Closing a Short Position
Suppose the Bitcoin price has gone in a favorable direction for you. Then you would like to close the position to lock in profits. It is also possible that your bet turn out to be incorrect, and exiting the position will limit your losses. In either case, you can use buy to close to buy another option contract, effectively closing out your short position.
Long and Short Options in the Same Position
It is also possible to have long and short options in the same position.
For example, an investor may buy a call option and sell a call option with a higher strike price as a hedge against potential losses. Such strategy is known as a vertical spread.
FAQ
Is Trading Options Good for Beginners?
Options on cryptocurrencies are a more complex tool than spot trading. Trading options involves a number of important for successful trading nuances. For this reason, options are considered to be best suited for experienced traders.
What Is the Difference Between a Call Option and a Put Option?
A call option gives you the right to buy a crypto asset, while a put option — a right to sell an asset at a set price before the expiration date.
Can I Lose Money Buying a Call?
Any financial instrument involves a risk of losing the initial investment. In the case of a call option, the potential loss of a buyer is equal to the amount of premium paid to the contract seller.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.
