Summary
This article discusses the meaning of Buy to Open (or BTO) in the context of shares, and asset options and provides examples. The article also delves into the rationale behind taking BTO positions, and the limitations of this investment strategy.
Buy to Open (or BTO) refers to an opening position that a trader could take in stocks, call options, and put options. Brokerages refer to BTO when a trader takes a long opening position in a call or put option or in shares. For example, if a trader purchases shares of Reliance Industries for the first time, it implies he or she is taking a BTO position in the said stock.
Understanding Buy to Open
In the case of options, a BTO call contract would give the purchaser the right to purchase the underlying asset at the call option’s strike price on the expiration date of the contract. In exchange, the purchaser of the call must pay a premium to the writer of the call contract. A trader would enter a BTO call contract if he or she believes the prices of the underlying asset are going to increase in the future.
If the asset’s price does increase, then the buyer of the call option can exercise the option by purchasing the asset at the strike price of the option and at the expiry date of the call option. The trader can then sell the asset at a higher market price and realize gains. Conversely, should the price of the underlying asset fall, the purchaser of the call would not exercise the option, and the call would expire worthlessly.
On the other hand, the purchaser of the BTO put contract would receive the right to sell the underlying asset. They can do so at the strike price of the put option at the put option’s expiration and in exchange for a premium payable to the writer of the put option. A trader would enter into a put contract if he or she believes that the price of the underlying asset is going to fall in the future.
If the price of the underlying asset does fall, then the buyer of the put option can purchase the underlying asset on the open market and sell it for the higher put strike price at the time of expiration of the contract. Should the price of the asset increase instead of falling, the purchaser of the put contract would not exercise the option, and the contract would expire worthlessly.
A BTO order indicates that a trader has taken a new position in the security or option, and not closed out an existing position in the investment. A BTO position can be closed by the trader making a Sell-to-Close (or STC) position in the security or option.
What are the reasons for taking Buy to Open positions?
A trader may use a BTO position in a stock or option for several reasons. These include:
- Opening a position in a stock or option: If the trader wants to venture into an investment in a particular security, they will enter a BTO position. A trader will also enter a BTO position if they take a particular stance on the future price of an asset via the purchase of call or put options for the first time
- Multiplying gains via relatively small investments: A BTO position taken in put or call options has the potential to magnify a trader’s gains if the trader’s forecast for the asset’s prices comes true, i.e., the options are in-the-money at maturity. Conversely, if the options expire out-of-the-money, the trader could lose his or her entire investment in purchasing the options.
- Hedging positions: Companies and other investors may purchase options on assets, including stocks, commodities, etc., as a means of hedging their exposure to these assets. Purchasing options is a relatively cost-effective method of hedging existing positions, akin to paying an insurance premium. We will take an example to understand this better.
Let’s say an investor owns 100 shares in Tata Motors, which is currently trading at INR500. If the investor believes the share price of Tata Motors will fall, he or she could enter a BTO position with a put option to sell at INR500, paying INR10 for each put option. If Tata Motors’ price falls as the investor expected, the loss will be avoided as the investor has purchased put options on the stock to sell it at INR500. However, the investor must pay for the put option to minimize their risk, and returns would be reduced by the cost of the option. Thus, we can see that buying an out-of-the-money put option combined with purchasing the stock can limit downside risk for the investor.
In Conclusion
Sometimes, it might become difficult for traders to obtain a BTO position in a stock or an option. Exchange rules may not permit opening positions in securities and options for specific periods, possibly due to delisting of the security, or stoppages in trading of the underlying security for extended periods of time. In such situations, traders can’t benefit by taking BTO positions. Traders interested in trading in BTO positions must be cautious and have a full understanding of what’s involved. For more details, they can consult a financial advisor.