Sell to Open vs Sell to Close Trading Strategies

By
Shikha Negi

Sell-to-open and sell-to-close are two of the four main order types used in options trading, apart from buy-to-open and buy-to-close. 

Sell to Open vs Sell to Close Trading Strategies

In options trading, investors buy and sell contracts that give them the right to buy or sell stocks at a set price within a certain time. Options can be traded on many stocks and some exchange-traded funds.

Options trading is a way of buying and selling the right to buy or sell a stock (or another asset) at a certain price within a set time. It’s like making a deal to buy or sell something in the future, but you don’t have to do it if you don’t want to.

There are two main types of options:

  1. Call options – These give you the right to buy a stock at a specific price before a certain date.
  2. Put options – These give you the right to sell a stock at a specific price before a certain date.

People use options for different reasons, such as protecting investments (like insurance) or trying to make a profit by predicting whether prices will go up or down. However, options can be risky, as you might lose the money you paid for them if things don’t go as expected.

Brokers and financial managers need to ensure that customers are suitable for trading options. This usually means that investors need to ask for permission from their brokers or online trading platforms before they can start.

A “sell to open” order is an instruction to sell or short an option in order to begin a new transaction. On the other hand, “sell to close” means closing a transaction by selling an option that was previously bought.

This comprehensive guide explores these two order types in detail, highlighting their mechanics, applications, advantages, and risks.

What is sell to open?

Sell-to-open is a transaction that involves writing (selling) a new options contract. In this case, the trader becomes the seller or writer of the option and receives a premium from the buyer. Sell-to-open positions are commonly used by traders who anticipate a particular movement in the price of the underlying asset and want to benefit from that expectation.

How does sell to open work?

  • Selling a call option: A sell-to-open order for a call option is executed when the trader expects the price of the underlying asset to decrease or remain stable. In this scenario, the seller collects a premium upfront and benefits if the option decreases in value or expires worthless.
  • Selling a put option: A sell-to-open order for a put option reflects a bullish outlook on the underlying asset. The seller receives a premium and may need to purchase the asset if the price falls below the strike price.

In both cases, the seller profits from the premium collected and any reduction in the option’s value before expiration. However, the risks differ for calls and puts, as they depend on the direction of the underlying asset’s price.

Example of sell to open

Suppose a trader sells to open a call option on a stock with a strike price of $100, expiring in three months, for a premium of $5. The stock is currently trading at $95.

  1. For a profit: If the stock price declines to $90, the call option may decrease in value to $2. The trader could buy to close the position for $2, securing a profit of $3 per share, or $300 (since one option contract covers 100 shares).
  2. At breakeven: If the stock price increases to $100, the option may retain its original value of $5. In this case, the trader could buy to close the position for $5, resulting in no profit or loss.
  3. At a loss: If the stock price rises to $110, the call option may increase in value to $8. The trader would need to buy to close the position for $8, incurring a loss of $3 per share or $300.

Key characteristics of sell to open

  1. Premium collection: The seller earns a premium upfront, which is the main source of potential profit.
  2. Obligations: The seller assumes the obligation to fulfil the contract if the buyer exercises the option.
  3. Risk Profile: Selling options can result in unlimited risk (for naked positions) or limited risk (for covered positions).
  4. Time Decay (Theta): The passage of time typically reduces the option’s value, benefiting the seller.

What is sell to close?

Sell-to-close is a transaction used to exit an existing long options position. It is executed when the trader initially buys an options contract (buy-to-open) and now wants to close that position. This allows traders to realise profits, minimise losses, or exit at breakeven.

How does sell to close work?

  • For calls: If the trader bought a call option expecting the price of the underlying asset to rise, they would sell to close when they no longer expect further price increases or wish to lock in gains.
  • For puts: If the trader purchased a put option anticipating a price decline, they would sell to close when they no longer anticipate further downward movement.

The decision to sell to close depends on the trader’s market outlook and the option’s current value.

Example of sell to close

Assume a trader purchased a call option on a stock with a strike price of $100, expiring in three months, for $5. The stock was trading at $95 at the time of purchase.

  1. For a Profit: If the stock rises to $110, the option’s value may increase to $12. The trader could sell to close the position for $12, realising a profit of $7 per share or $700.
  2. At Breakeven: If the stock rises modestly to $100, the option’s value might remain at $5 due to time decay offsetting intrinsic value gains. Selling to close at $5 would result in no profit or loss.
  3. At a Loss: If the stock rises slightly to $96, the option’s value might drop to $2 due to insufficient price movement. Selling to close at $2 would result in a loss of $3 per share or $300.

Key Characteristics of Sell to Close

Sell to close is a critical action in options trading that allows a trader to exit an existing long position. Below are its key characteristics:

  1. Purpose: Sell to close is used to exit an existing options position that was opened using a buy-to-open order. It enables the trader to realise profits, mitigate losses, or close the trade at breakeven.
  2. Closing a long position: This transaction is executed when a trader has purchased an options contract (long position) and now wishes to sell it back to the market.
  3. Profit or loss realisation: If the market moves favourably, the trader may sell to close the position at a higher price, realising a profit. Conversely, if the market moves unfavourably, the trader may sell to close at a lower price, incurring a loss.
  4. Impact on open interest: A sell-to-close transaction reduces open interest if it fully closes a position without transferring the contract to another party. If the contract is transferred to a new buyer, open interest may remain unchanged.
  5. No future obligations: Once the position is sold, the trader has no further obligations or rights associated with the option contract. Unlike sell-to-open, which creates obligations, sell-to-close does not involve any additional commitments.

Sell to open vs sell to close: key differences

 

Aspect Sell to Open Sell to Close
Purpose To write a new options contract To exit an existing options position
Position type Creates a short position Closes a long position
Premium Collected upfront Realised upon sale
Market sentiment Bearish (calls) or bullish (puts) Dependent on the original position
Risk exposure High for naked positions Limited to the initial cost of the option
Impact on open interest Increases open interest Reduces open interest if position closes

Final thoughts

Sell-to-open and sell-to-close are important terms in options trading, and each has a specific purpose. Sell-to-open means creating new options contracts to take a short position, while sell-to-close is used to exit an existing long position. Both types of orders require a good understanding of market behaviour, risk management, and trading goals.

For traders, learning these concepts is important for building strong strategies and achieving long-term success in options trading. Like any financial investment, knowledge, discipline, and hands-on experience are essential for understanding and managing the challenges of the options market effectively.

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