What is Sell To Open?
How does a sell to open option trade work?
What are the essential elements you should know!
In this article, I will break down the notion of Sell To Open so you know all there is to know about it!
Keep reading as I have gathered exactly the information that you need!
Let’s understand “sell to open” transactions and how it works in option trading!
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What Is Sell To Open
Sell to open is a phrase used in the brokerage industry where traders refer to the process of shorting options or various derivative products.
In other words, when a trader “opens” a short position in options, he or she is able to receive some money for the options.
When a trader opens a short position in options, if he or she owns the underlying assets, we’ll say that it’s a “covered” position and if the assets are not owned, it is referred to as a “naked” position.
The process of “selling” to “open” allows a trader to receive a premium (an amount of money) for allowing the option buyer to exercise the option prior to the expiration of the option contract.
Types of Options
Options are a type of derivative security and come in two types:
- Call options
- Put options
A call option is a type of options contract where the buyer of the call option bets that the price of the underlying stock will go up whereas the seller believes that the price will not go beyond the strike price.
If the stock price goes above the strike price, the buyer makes money by being able to by the stock at the strike price being below the actual market price.
However, if the stock price does not go beyond the strike price, the buyer of the call option will not exercise the option and the seller makes money by keeping the premium received.
Now let’s look at put options.
The buyer of a put option is an investor betting that the price of the underlying stock will go down.
As a result, the buyer of the option hopes to be able to make money by forcing the seller of the option contract to buy the underlying stocks at a price higher than the stock’s market price.
On the flip side, the seller of a put option bets that the underlying stock will go up in price.
If the underlying stock price goes up, the buyer of the put option will not have any incentive in exercising the option and so the seller of the put option makes money by keeping the premium received.
When you initiate a sell to open trade, you are either selling an option contract (taking a short position) or writing an option contract giving someone the right to exercise their option during the term of the option contract.
By selling or writing an option contract (can be a call option or a put option), you are effectively receiving a premium.
In essence, the premium that you receive reflects the market value of the option contract that you are selling which includes both the extrinsic value of the option contract along with its intrinsic value.
The extrinsic value is a reflection of “time value” and the “implied volatility” of the stock whereas the intrinsic value is whether or not the option is “in the money”.
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How A Sell To Open Trade Works
The way a “sell to open” transaction works is that an option trader (or investor) opens an options trade by taking a short position (or selling) in an option.
By selling options, the investor is able to receive the premium from the buyer of the option.
In a sell to open transaction, the seller of the option assumes a short position on the call option or put option whereas the buyer of the option takes a long position on the same option contract.
The way the trader can make money with a sell to open trade is by anticipating that the underlying asset price will not move over the option strike price until the option expires.
In this fashion, the trader is able to keep the premium paid by the buyer.
However, if the underlying stock price goes above the strike price, then the buyer of the option having a long position will win.
Sell To Open Call
You can establish a sell to open trade on call options (referred to as sell to open call).
If the option investor owns the underlying securities, the sell to open call will be referred to as a sell to open covered call (otherwise it will be a sell to open nake call).
Let’s look at a sell to open call option where the transaction is covered.
When an investor establishes a sell to open covered call, the investor is effectively taking a short position in a call option where he or she owns the underlying stocks.
In this case, the investor’s objective is to collect the premium paid by the buyer of the option and hopes that the buyer of the call option does not exercise the option until the call options are expired.
Sell To Open Put
You can also establish a sell to open position on put options (referred to as sell to open put).
When the investor owns the underlying securities, the sell to open put option is referred to as sell to open covered put (and if the stocks are not owned it will be a sell to open naked put).
For example, investors may want to establish sell-to-open puts to make money from the premium received by selling the options.
The investor selling a put option considers that the underlying stock can perform neutrally or go up in price and so he or she is willing to take the risk of selling a put option hoping the stock price will not drop.
If the stock price does not drop, the buyer of the put option will not exercise the option and so the investor makes money by keeping the premium received.
However, if the stock price falls below the put option strike price, then the buyer of the put option wins as he or she can “put” the option to the seller.
Option Trading Terms
There are different types of option trading terms out there that you will want to familiarize yourself with if you are interested in options trading.
To start with, when you trade options, there are fundamentally four types of basics option trades:
- Buy a call option
- Sell a call option
- Buy a put option
- Sell a put option
Now, you can be on either side of the transaction as the options seller or option buyer but no matter on which side you are on, these are the four fundamental option trades you have available to you.
There are different terms used to refer to different types of option trading positions.
Let’s look at some of the common option trading terms used in the industry:
- Buy to open
- Sell to open
- Sell to close
- Buy to close
When you “buy to open”, you are essentially buying a call option or a put option (going long) to open your trade position.
When you “sell to open”, you are writing a call option or put option (meaning that you are selling an option contract) to open your trade position.
When you “sell to close”, you are a holder of an option contract and you are looking to sell your call option or put option.
Finally, when you “buy to close”, you are a writer of an option contract and you buy a call option or put option to close your position.
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Comparing Sell To Open To Other Trades
What is the difference between a sell to open vs sell to close trades?
Selling To Open Options
When you “sell” to “open” a call or put position, you are either writing an option contract or taking a short position in a call or put option contract.
The reason why you are selling to “open” is that you are taking a new trading position or you are initiating a new trade.
By short selling or writing a contract, you are effectively collecting a premium for giving the option buyer the right to exercise his or her options based on the terms of the contract.
If the option buyer does not exercise the option, you win as you keep the premium that you collected.
If the option buyer exercises the option, you lose.
Selling To Close Options
When you are “selling” to “close” a call or put option position, you are a person having a long position in a call option or a put option.
In other words, you have opened your trade position by “buying” a call option or a put option and how you are looking to close your position by “selling” it.
Since you already own the option position, by selling your option contract, you can effectively exit your trade position.
Buying To Open Options
When you are “buying” to “open” an option position, you are essentially buying a call option or put option to initiate a new trading position.
To buy the option, you are going long.
To open an option position, you are initiating a new trading position.
Buying To Close Options
When you “buy” to “close”, you are the writer of an option or you have shorted option contracts and now you want to exit your trade position by buying the option contract.
To close the option position, you are looking to exit the option trade or close the trading position you previously opened.
To buy the options with the intention of closing your trade position means that you have a short position or you wrote a contract and you need to take a long position to exit or open trade.
Sell To Open Example
Let’s look at an example of a sell to open trade to better illustrate the concept.
Imagine that you (as a trader) believe that the stock price of a particular company is going to go down in the next weeks.
Based on this assumption, you want to make some money by selling an option contract.
What you’ll need to do is to sell a call option contract to open an option position for yourself (sell to open call option position).
In other words, you are taking a short position on a call option and receive a premium for selling the option to the call option buyer.
Unlike you, the buyer of the call option contract (who has a long position) is betting that the stock price will go above the strike price.
Now, if you are right and the stock price goes down (or does not go above the call option strike price), you win as you can keep the premium received and the buyer will not exercise his or her option.
However, if the stock price goes above the call option strike price, the buyer will exercise his or her option and you will lose.
Sell To Open Meaning Takeaways
So there you have it folks!
A sell to open option trade refers to a trading position where you write an option contract or sell an option contract to take a short position.
In other words, you are “opening” a trade position (or initiating a new trade) where you are “selling” an option contract or “writing” one.
When you are selling to open, you are opening a short option position or writing an option contract.
The reason why you may want to sell to open is that you are looking to make money by collecting some premium from the option buyer and hoping that the option you shorted or sold does not get exercised.
So the objective sell to open is not to bet on the market price of the stock but to make money by collecting premiums on an option contract.
Now, if you want to bet on the direction of the underlying stock price, you will then need to decide if you are going to sell to open a call option or a put option.
If you sell to open a call option, you are betting that the stock price will go down (whereas the buyer of the option is betting the stock price will go up).
If you sell to open a put option, you are betting that the stock price will go up (whereas the buyer of the put option is betting the stock price will go down).
I hope this article was useful in helping you understand the notion of sell to open in options trading.
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