So you’re relatively new to trading options and you want to execute a buy order. But when you pull up your trading platform you notice there are four things to choose from. How come there’s more than two choices?
As if learning to trade options wasn’t already stressful enough, now you can’t even click a button without some extra anxiety. Placing an options order can be a bit confusing if you expected to only see a buy and sell option.
With options (calls or puts) there’s really only two choices when placing an order; open a position or close a position. First, let’s discuss how to open a trade.
Understanding the Basics of Trading Options: Buy to Open, Sell to Open, Buy to Close, Sell to Close
When opening a trade, you can either go long or short the option. It doesn’t matter whether it’s a call or put, you can still go short or long on both.
We’re not going to discuss strategy at this point, simply the mechanics of each order entry.
Buy to Open
This is the order that most beginner option traders use the most. If you’re looking for the stock to go up, you’d want a buy to open order on your call option. Thinking the price of the equity is heading lower? Buy to open a put option.
Unless you’re doing more complex options strategies this is probably the entry order you’ll use the most.
Sell To Open
If you’re looking to short an option you’ll be entering a sell to open order. When you enter the sell to open order for a call option, you’re expecting the stock price to drop. You’d make money buying it back when the option’s value had decreased.
The same idea applies for a put option. A sell to open order for a put would become profitable as the stock price rises.
These types of orders typically require more capital reserves by most brokers. The reason is losses can quickly spiral out of control if the stock moves sharply against you.
A covered call trade is an example of a sell to open order that won’t be a naked option position like other sell to open orders. Covered calls are considered ‘covered’ because you need to own 100 shares of stock for every contract you sell.
Whenever you enter a sell to open order you either need cash or stocks to back up the order or your broker won’t let you execute the trade.
Now that you know how to open a trade, let’s look at how you would close the above two orders.
Sell to Close v. Buy To Close
Closing out any trade requires the reverse of how you entered it. If you opened it with a buy to open order, you’d close it with a sell to close. Conversely, a sell to open trade can only be closed with a buy to close order entry.
Sell to Close
This is the only way to close any position you opened with a buy to open order. It doesn’t matter if it’s a call or put, both are closed out this way.
Just like the buy to open order, this is the most common way you’ll exit a position. It’s also a lot more straightforward to understand. Selling to get out of a trade seems completely natural. This is especially true if you happen to be panic selling and you can’t seem to click the sell button fast enough.
Buy to Close
Surely the first time you saw this order type you probably thought, ‘how is that even possible’? How can buying an option get you out of a trade?
Thinking back to the sell to open entry order, this simply undoes that trade.
When you shorted that call or put option, the only way to cover or exit your trade is to buy it back. That’s exactly what the buy to close order does.
This is also the order type you’d use when closing out a covered call trade.
The good thing about these two exit orders is that even if you click on them by accident, it won’t fill if there isn’t an open order to close. With the buy to open and sell to open orders, both will trigger if your account has enough funds so be extra careful with those taps and mouse clicks.
All four of the above order types can be entered by themselves or in combination with other orders know as spreads.
A spread order can entail buying to open one particular option while at the same time entering a sell to open order for another. Spreads can either be debit spreads or credit spreads. Debit spread trades takes money out of your account. A credit spread usually results in money being deposited into your account at the beginning of entering the position.
Debit and credit spreads are a discussion for another time.
A final note about entering options orders. Some brokers may abbreviate the order types to just three letters.
Buy to open would be BTO.
Sell to open is STO.
Buy to close displays as BTC.
Sell to close is of course STC.
Most trading platforms allow you to customize how the buttons show up in your order entry window. Set this up so it’s as easy as possible to enter the right order.
Even experienced traders and investors sometimes mistakenly enter an order they didn’t mean to. When that happens, and it will eventually, don’t be a hero. Immediately get out of that trade and wait the for setup you actually intended.
Everyone makes and will make trades that go against them. Don’t hope for a mistake to turn into profits. As you should already know, hope is not a strategy.
Now that you know what all those order types mean, it’s time to go out there and grow that account.
If clicking a button was only that easy.