Wait, what? You can sell an option to open a position, and sell an option to close a position? How?
If you’re not already familiar with this, it’s a lot simpler than you may think. Selling to open and selling to close are really just phrases that mean closing a long position (where you had purchased a security) and opening a short position (where you borrow a security and sell it).
And with options trading, there are a few more layers to selling to open or close than there are when you long or short common stock. Options open the door to a new world of possibilities and interesting ways to profit. Not understanding these can be very dangerous.
First and foremost we’ll go over the quintessential terms associated with options trading. Then, we’ll explain the two types of options before we get into not only how to sell to open and close, but compare and contrast the two plays so you have the know-how necessary to get started trading options.
Sound good? Let’s get to it!
What you’ll learn
Options Trading Terminology
The two most basic terms you need to know are calls and puts. A call allows you to “call” stock away from somebody else, and puts allow you to “put” stock to someone else. We’ll get into some more details about calls and puts in the next section.
Next up is an option’s premium. The premium of an option is just the price of the contract – it’s the cost that the trader must pay, similar to a ‘fee’. You’ll typically see premiums represented in premium per share.
So for example if a contract has a premium of $7.50 per share, and since option contracts represent 100 shares, the total premium of the contract is $750.00. There are many factors that affect the premium of an option, and it’s crucial that you understand the basics of what goes into option pricing. With this, you will be able to better determine what influences the value of the contract, and at which price point you’ll need to sell (sometimes this can be deceiving – we’ll clarify a bit later).
Next we’ll go over an option’s strike price. A strike price is the price that you are allowed to buy (if you purchased a call option contract) or sell (if you have a put) the underlying security at. The strike price is the key in determining if an option is in-the-money (ITM), out-of-the-money (OTM), or at-the-money (ATM).
If you bought a call, the option is ITM when the strike price is below the current share price of the underlying security. This is because it would be more advantageous for you to have the right to buy a security below the current price, thus making it more valuable than a call that is OTM, when the strike price is above the current price. ATM just means the strike price is the same as the current underlying price.
Therefore, contracts that are ITM are more expensive (they have a higher premium) than OTM contracts because they provide more value.
For puts, ITM & OTM are the reverse. A put is ITM when the strike price is above the current price, because it is better for you to be able to sell a security for more than its current price.
The next factor that affects an option’s premium is its expiration date. Remember that with options, you only have the right to buy or sell stock for a set period of time. This is the time in between when you purchase or sell a contract, and when the contract expires. The further out an option’s expiration date is, the higher the premium will be. This is because the contract has more time to increase in value.
Time decay is something that affects an option’s premium based on each day that passes as options near their expiration date. Traders can think of the effect of time decay and an option’s value like how the sun affects ice cream. As time passes, the ice cream melts, just like the value of an options contract.
These are key terms to be aware of before you start trading options, and even if you have already jumped into the world of options, a healthy understanding of these terms and influencers to an option’s value will serve you well.
Now that we’ve gone over premium and factors that influence it, let’s talk about how to use the rights described in the contract. How do you use the contract to purchase or sell 100 shares of the underlying security? You do something that’s called exercising the contract. You literally exercise your right. When you exercise your contract, the contract is then assigned to the person who sold it to you on the other end. This is referred to as assignment.
If you sell a contract to someone, you always run the risk of assignment, because if the person you sold the contract to decides to exercise it, you will be responsible for either selling 100 shares of the security, if you sold a call, or buying 100 shares of the underlying security if you sold a put.
With those terms in mind, let’s jump into the types of options contracts, and after that we’ll tie everything together with some examples.
Types of Options Contracts
This information should be a little bit easier to digest, because while there are a myriad of strategies used in options trading, there are only two types of contracts. The two most basic types of options contracts are calls and puts.
The first type of contract is referred to as a “call”. A call gives you the right, but not the obligation, to sell stock at a set price, over a set period of time. A “call” is a contract that represents 100 shares of an underlying stock. Option contracts are derivatives of securities, therefore the security they’re associated with is the “underlying” and the option itself is the derivative of the underlying.
The next type of contract is called a “put”. A put is sort of the inverse of a call. Puts give you the right to sell stock at a set price over a set period of time. Puts are also contracts that represent 100 shares of the underlying security, which is more often than not shares of stock.
What is a ‘Sell to Open’ Order?
A ‘sell to open’ is a type of order made in options trading which may seem like the more confusing phrase out of the two. Because we know that if you long (own) common stock and sell it, you close your position. So how could you open a position by selling an option?
You can short, or sell options, aka write a contract, and the dynamics of shorting options have a lot more layers than shorting common stock. With a sell to open order, a trader opens a position (meaning they initiate an options trade) by selling a short position in that same contract that they just opened.
This is how it works: you choose a stock, the type of contract, the strike price, and the expiration date, and then you sell the contract. See – not so complicated, right? Yet – there are some additional factors to consider.
‘Sell to Open’ – Premium
This is an interesting aspect of options. When you short common stock, all that happens is you borrow from your brokerage and trade with another investor, generating profit as the security’s price falls.
With options, you receive a premium from the investor who bought the contract, and your goal is to keep that initial premium received. This means that you don’t want the underlying price to move only a little bit, and optimally stay neutral.
Rather, it’s in your best interest for the underlying security’s price to move quite substantially. This will in-turn increase your profit at the end of the day.
‘Sell to Close’ Order Explained
When you sell an option you long, you have closed the position. This is what the phrase sell to close means. And actually, only about 10% of options are actually exercised, so more often than not they’re sold, thus closed before expiration.
In this sense, selling to close is pretty straightforward. Selling to open has several different layers to it, and can be complex – but selling to close is essentially a one-step process. To ensure it’s clear, let’s dive into an example to really bring this idea to light.
An Example of ‘Selling to Close’
Let’s look at an example of a sell to close order. This works in the same way as closing a position with shares of stock that you long. You long, or buy stock, and to close the position you sell everything you long.
So let’s say you are bullish on Twitter (TWTR), so you decide you want to long a call. The share price is $49.00, and you want to buy an in-the-money call that expires in two weeks, May 13. The strike price is $47.00, and the premium per share is $3.03, so the total cost of the contract is $303.00. Twitter goes up by 3.00% by May 4, so the current share price is $50.47, and this has increased the premium of your option by 18%.
So on May 13 your TWTR call is worth $3.58 per share, and you decide you want to close the position. Make sure that you enter a limit price, which is the limit you want to set on the price you sell. You set your limit price to $3.58, and sell the contract. You have now sold to close. And your total profit is the difference between the premium you bought the contract for and the premium you sold it for. ($3.58 – $3.03) * 100 = $55.00.
The other thing you could have done to close the position is exercise the contract, like we had mentioned earlier. To exercise, open the specific position in your brokerage, and there is usually a button that says “exercise”. Typically you only want to exercise if you are protecting yourself from assignment (if you sold an option), if position isn’t liquid enough and you’re in the unfortunate position of not being able to sell the contract, or if you just want to own shares of the underlying.
For the sake of this example let’s just say you want to own 100 shares of TWTR so you exercise. Your contract says you can buy at the strike price, which is $47, and its trading price at the time you want to sell is $51. You exercise the contract, and buy 100 shares of TWTR for a total cost of $4,700.
You can then sell that stock back to the open market for a total of $5,100, so your profit in this case would be $400. You just need to make sure you have the capital to cover your decision.
Next, we’ll go over a sell to open example, which has a couple more layers to it than a sell to close.
An Example of ‘Selling to Open’
Typically when you short a security, or common stock, you feel bearish and earn money from the investment as the price drops. But with options, a recurrent strategy with options traders is to open a short position by selling one or more contracts when you feel neutral towards the underlying price, meaning you don’t think it will move very much.
This is because if the underlying price moves in a favorable direction for the person who bought the contract, you risk assignment, and if it moves in the other direction, you can lose some, if not all of the premium you initially collected.
Now for the example. Say you feel that Apple’s (AAPL) price won’t move very much in the next week and a half. The share price at the time you open is $160.00. What you would do to create a sell to open is choose all of the parameters you’d like, including the strike price and expiration date. In this example we’ll sell a call with a strike price that is ITM. The call has a strike price of $155, expires on May 13, and has a premium of $6.40. But, instead of buying the contract, we sell it.
By selling the contract, you receive $640.00 in premium from the person who bought the contract. You now have an active, open order, and you want the stock’s price to not move very much so you can keep your $640 initially received. By May 10 AAPL’s price hits $157.5, you still have the premium you initially received, and you want to close your position. You can close sell-to-open positions by buying the contract back.
You buy the contract back, which would be known as – you guessed it – “buying to close”.
Now, it’s very important that you know that you expose yourself to a theoretically infinite amount of risk by selling an option, just as you would if you are shorting common stock. If you sell an option without hedging against that risk, that is known as selling an option “naked”. So you want to cover your position by longing 100 shares of the same stock. There’s a significant difference between “covered” options and “naked” options, with covered options being much safer.
However, covered positions can be quite expensive to open, which can be preventative for some traders. It’s always a good idea to make sure you are covered in case something goes very wrong, which is always possible. But if you don’t have the capital to cover your position, you need to be very careful and watch the position closely to avoid potentially catastrophic losses.
Below are two graphs that can help explain profit/ loss from a sell to open position, and what the break-even points are.
Example of a sell to open through a call option:
Below we can see a sell to open example through a put option:
‘Sell to Open’ vs. ‘Sell to Close’ – Comparison
It’s a good idea to hedge, or cover every trade you make, but it is more important to cover sell to open positions, so they typically require more upfront capital. They also profit very differently. Where with a sell to open, you are looking to keep the premium you received, and with a sell to close you are looking to close the position for more than you initially bought it for.
Lastly, with long option positions, you have the right to exercise your contract, but with sell to open positions, or short positions, you can’t exercise the contract, but instead run the risk of assignment, which is why it’s a good idea to have those 100 shares ready. Covered calls and puts and married calls and puts are slightly more advanced strategies than simply longing or shorting a contract, but worth looking into to be a smarter trader. In access these types of options however, you’ll first need to be granted the appropriate permissions from your brokerage.
In conclusion, selling to open and selling to close are two completely different strategies, both with their benefits and downsides. Selling to close means you are selling a position you already long in order to close it, and selling to open means shorting one or more contracts to open a short position.
It’s important to ask yourself what you are trying to accomplish, where you think the underlying price is going to go, why you think that, and how much risk you’re willing to assume. Answering these questions will help you determine which strategy will work the best for you.
Sell to Open vs. Sell to Close: FAQs
What Does it Mean to Sell to Open?
Selling to open means you sell, or short a security. In the case of this article, we are referring to options, so selling an option is also referred to as writing a call/ put. When you sell to open, or short, you are borrowing money from your brokerage to open a position, with the hope to buy it back for less in the future. With options, if the contract expires you keep the premium you initially received for selling, or writing the contract.
What Does Sell to Close Mean?
Sell to close means you sell a position you own. You close the position you long, or purchased. Securities and derivatives work similarly in this way, in that you buy shares of a security or a contract(s) and then sell it back for hopefully more than you bought it for.
Is a Covered Call Sell to Open or Sell to Close?
A covered call, also known as a covered call spread, is a sell to open position. This is often referred to as writing covered calls; and “writing” a contract is synonymous with selling an option contract. Covered means you protect yourself against possible assignment by either shorting or longing 100 shares of the underlying depending on if you sold a call or a put.
What is the Difference Between a Call Option and a Put Option?
A call grants you the right to buy stock, while a put grants you the right to sell. The right to buy or sell the stock that the option contract is associated with is only within a certain period of time, and this is between the time you open the position to when you close it.
Is Options Trading Good for Beginners?
It is not a good idea to trade options if you are a beginning trader. Beginner traders should be extremely careful even considering trading options. It’s crucial to realize that when you trade just one contract, it represents 100 shares. Gains, and, notably, losses, are magnified; not by 100x, but they are magnified, kind of like how leveraged positions work.
If you do decide to start trading options and you don’t know much about them, you should consider practicing with a demo account and subscribing to options alert services to receive notifications of potentially profitable trades from experienced traders. There are also lower-risk strategies to employ initially, such as the straddle. A straddle is when you long both a call and a put with the same strike price and same expiration. That way you’re protected against heavy losses if the underlying security moves in either direction.
When Should You Sell to Close?
The most optimal time to sell to close is when your position has grown, so that when you close it, you sell it for more than what you bought it for. This is the most well known concept of investing.
When Should You Sell to Open?
With options specifically, generally you should sell to open when you are feeling neutral towards the direction of the underlying price. You don’t want the option you sold to move too far in either direction. If it moves away from what you want, you start to lose the premium you initially received from selling the contract.
It can also move in a favorable direction for the person you sold the contract to and you risk them exercising the contract, so you get assigned the rights described by the buyer of the contract, so you either have to buy or sell them 100 shares of the underlying security.
Does Closing a Position Mean Selling?
No, closing a position doesn’t always mean you are selling. The only time closing a position means you are selling it is when you are “selling to close”. If you are selling to open, you are actually opening a position.