How To Open and Close Option Position

In our previous article we discussed that buying an Option gives the holder the “choice” to either exercise the Option or just let the Option expire. However, those are not the only choices an Option Holder can make. Most buyers of Options sell the Options before the expiration date. So that’s an additional choice on top of two mentioned: whether to sell the Option or not before it expires.  In fact, as can be seen in the graph below 70% of Option buyers close an Option Position by selling the Option they bought before the expiration date.

Selling an Option after buying it is one way of Closing an Option Position.  However, what does it mean to Close an Option Position? And what is an Option Position in the first place?

Option Position Defined

An Option Position is the amount of security either owned or borrowed when dealing with Options. When an investor enters into an Options Trade, he is Opening an Option Position. When the investor exits the Options Trade, he is Closing the Option Position.

Remember that there are two sides in an Option Contract, the buyer and the seller. Both the buyer and the seller can Open and Close Option Positions.

Opening an Option Position

Opening an Option Position involves one party (buyer) buying the Option and another party (seller) selling the Option. The Option gives the buyer the right to buy from or sell to the other party a fixed number of the underlying asset at a fixed price (called the strike price) on or before the expiration date. The buyer pays the seller a premium for acquiring such right. In the conduct of this trade, the buyer opens an Option Position through a Buy-to-Open Transaction while the seller opens an Option Position through a Sell-to-Open Transaction.

Closing an Option Position

Once an Option Position is opened, it will be closed eventually. For example, when the expiration date arrives, the Option expires and the Option Position closes naturally. However, there are more active ways in Closing an Option Position. The most common way as mentioned earlier is for the buyer to sell the Option before the expiration date. Furthermore, buyers are not the only ones who can exit an Option Position before the expiration date. Sellers as well can Close their Option Position before the expiration date.  The process of selling a previously bought Option and buying back a previously sold Option is called Offsetting. Offsetting reverses a previous transaction in order to exit an Option Position.

Types of Option Transactions in Opening and Closing Positions

Hence, there are 4 types of Option Transactions that can occur when investors engage in Opening and Actively Closing an Option Position. These are as follows:

1. Buy-to-Open Transaction
2. Sell-to-Close Transaction
3. Sell-to-Open Transaction
4. Buy-to-Close Transaction

Numbers 1 and 2 are transactions involving the buyer of the Option while numbers 3 and 4 are transactions involving the seller of the Option.

Buy-to-Open Transaction

When one party (buyer) pays a premium to buy an Option regardless whether the Option is a Put Option or a Call Option, the buyer is Opening an Option Position. Such transaction is called a Buy-to-Open.

Sell-to-Close Transaction

When the same buyer mentioned above sells the Option he bought before the expiration date, the buyer is Closing the Option Position. Such transaction is called Sell-to-Close.

Sell-to-Open Transaction

When one party (seller) accepts a premium to sell an Option regardless whether the Option is a Put Option or a Call Option, the seller is Opening an Option Position. Such transaction is called Sell-to-Open.

Buy-to-Close Transaction

When the same seller mentioned above buys back the option he sold before the expiration date, the seller is Closing the Option Position. Such transaction is called Buy-to-Close.

A summary of the ways at which buyers and sellers of Options can Open and Close Option Positions is shown below:

Knowing when to Open and Close an Option Position is a very important skill that investors and brokers of Option must possess. Such skill, when harnessed properly, can result to enormous profits.