Dykstra: Limiting Downside Risk

Q: Can you explain the difference between a "buy to open" and a "sell-to-open" order?

A: There are several ways to buy and sell stocks and options. You can buy a stock and sell it later; and you can sell a stock and buy it later, which is called shorting the stock. The same works with buying and selling options.

My strategy calls for buying options, then selling them later. These orders are placed using a "buy-to-open" limit order.

Now let me explain the difference. When we buy a call option contract, we are essentially paying for someone to guarantee to sell us the stock at a set price and on or before a set date. Then when we sell the contract, we are giving someone else the right to buy the stock. That is our strategy, and it limits our risk to the amount we paid for the option.

However, if we sell an option as an opening order, we need to either own the stock or have the ability to buy it. In "covered call writing," which is used as a hedge against falling stock prices, you sell options and own the stock.

Most option contracts sold are written by covered call writers. When you use this strategy, your risk in the trade is that the stock will be called away, in which case the option buyer will exercise the contract and you will be required to sell it. To avoid having your stock called away if the stock price goes up, covered call writers will buy another option contract to cancel out the first order, taking a loss in the premium difference.