SELL TO OPEN: Overview, How It Works, Practical Example

SELL TO OPEN
SELL TO OPEN

Options have the most trading orders of any publicly traded financial instrument in the world. One of the first things that astonish options trading beginners, as well as one of the first mistakes options traders make, is the variety of trading orders available. Indeed, using the wrong orders would almost certainly result in unnecessary losses and frustration, making an understanding of how they work critically. Options traders use four types of trading orders: Buy To Open, Sell To Close, Buy To Close, and Sell To Open. In this tutorial, we will attempt to explain and comprehend the phrase “sell to open” (calls and put options). Also, note the distinction between “sell to open” vs “sell to close” below.

What is Sell to Open?

A “Sell to Open” options trade order is used to start a short option position by writing or selling an options contract. When a person sells to open, he or she is establishing a short options position. A sell to open can be thought of as “opening an options contract by writing or selling.”

Understanding the Sell to Open Process

“Sell to open” refers to situations in which an options investor starts an options trade by selling or establishing a short position in an option. This allows the option seller to receive the buyer’s premium on the other side of the transaction. Derivative securities include options.

An investor earns a premium by selling the opportunity associated with the option to another investor in the market. The selling investor is now in the short position on the call or put, while the second investor is in the long position, which is the purchase of a security in the hope that its value will rise.

The short investor hopes that the underlying asset or equity does not move above the strike price, allowing them to keep the underlying security and benefit from the long investor’s premium.

Sell to Open Options. 

An option in the stock market is a contract between two people, one of whom is the seller and the other the buyer. When you are the buyer, you have the right, but not the obligation, to purchase or sell a security at a specific price and within a specific time frame. When you are the seller, you are obligated to buy or sell the security for a specific price within a specific time frame.

Calls and puts are the two main types of sell-to-open options. Either can be purchased or sold. A call option buyer is bullish and believes the underlying stock will rise in price before the option expires. A call option seller is bearish and believes the price will remain unchanged or fall.

The buyer of a put option anticipates that the underlying stock will fall below the strike price before expiration, whereas the seller anticipates that the price will remain the same or rise.

There are two kinds of options. One party is long and one party is short for each type of options contract:

  • Sell to open calls option
  • Sell to open put option

Let’s take a look at each option one by one.

Sell To Open Calls

As the seller of the calls, you believe the underlying stock will remain unchanged or fall in value before expiration. Your sell-to-open calls option gives you the right to buy 100 shares of stock at a predetermined price before the contract expiration date. This section is the same regardless of the type of call option you choose to sell. The reason for selling a call option is the same: to profit by keeping the contract’s premium.

The following are the various types of sell-to-open calls to be aware of:

Buy-write call/covered call

This is when you sell a call option on a stock that you own. “Covered call writing is a very conservative investment strategy and a method to generate additional income,” says Creighton University finance professor Robert R. Johnson. A covered call writer is essentially selling some upside potential in exchange for additional current income. This is especially beneficial for investors who are nearing retirement and looking for additional income. You could already own the stock or purchase it when you write (sell) the option.

Naked call.

To begin with, you do not own the underlying stock in this scenario. If the stock is at or OTM at the time of expiration, you keep the premium and the contract is worthless. If the underlying stock is ITM, you must purchase it at a higher price and then sell it to the buyer at the lower strike price. The premium plus the strike price minus the cost of purchasing the stock at the new higher price will be your profit (or loss). These losses may be limitless.

Sell to close.

This is when you, as the original buyer of call options, decide to sell your option to profit from an ITM stock. You could do this instead of exercising your option with the original seller. You sell your option to a new buyer and keep the premium as a profit. Your position has been filled.

If the new buyer exercises their option before it expires, the original seller may be forced to sell the stock to them at the new strike price. The main advantage of selling to close is that, as a buyer, you can convert to a seller before the expiration date and avoid commissions and other fees.

Benefits and Drawbacks of Sell To Open Calls

The sell-to-open calls option, like most types of investing, has both upside and downside. The benefits include earning additional (premium) income on the stock you already own or on stock you do not own. This is a repeatable action, which means you could sell a one-month covered call 12 times in a year. Finally, the premium you receive is paid in advance and is yours to keep regardless of what happens.

The downside of the sell-to-open calls option is that premiums are limited, limiting profit potential. You may miss out on a large positive swing in the underlying stock if you are unable to sell it without first buying back the contract. Worse, depending on the type of call option you sell, your losses could be limitless.

Sell To Open Put

A sell-to-open put option grants you the right, but not the obligation, to sell a stock at a specific price (the strike price) by a specific time (the option’s expiration). The buyer exercises this right by paying a sum of money known as a premium to the seller. In contrast to stocks, which can exist indefinitely, an option expires and is settled, either with some value remaining or with the option expiring worthless.

The following are the main components of a sell-to-open put option:

  • Strike price: The price at which you can sell the underlying stock.
  • Premium: The price of the option, for either buyer or seller
  • Expiration: When the option expires and is settled.

A “contract” is one option, and each contract represents 100 shares of the underlying stock. Contracts are priced based on the value per share rather than the total contract value.

How Does a Sell-To-Open Put Options Work?

When the stock price is less than the strike price at expiration, the sell-to-open put option is in the money. The put owner may exercise his or her right to sell the stock at the strike price. Alternatively, the owner can sell the put option to another buyer at fair market value before it expires.

When the premium paid for a sell-to-open put is less than the difference between the strike price and the stock price at option expiration, the owner profits. Assume a trader pays $0.80 for a put option with a strike price of $30 and the stock is $25 at expiration. The option is worth $5, and the trader has made a $4.20 profit.

If the stock price is higher than the strike price at the time of expiration, the put is worthless. Any premium received for the option is kept by the put seller.

Purchasing a Put Option

Sell-to-open put options can act as a form of insurance. A stockholder can buy a “protective” put on an underlying stock to help hedge or offset the risk of losing money if the stock price falls.

Importantly, investors do not need to own the underlying stock to purchase a put. Some investors buy puts to bet that the price of a stock will fall because put options offer a higher potential profit than shorting the stock outright.

If the stock falls below the strike price, the sell-to-open put option is considered “in the money.” An in-the-money put option has “intrinsic value” because the stock’s market price is lower than the strike price. The buyer now has two options:

  • First, if the buyer already owns the stock, the put option contract can be exercised, transferring ownership of the stock to the put seller at the strike price. This exemplifies the “protective” put because, even if the stock price falls, the put buyer can still sell the shares at the higher strike price rather than the lower market price.
  • Second, the buyer can sell the put before it expires to capture the value without having to sell any underlying stock.

If the stock remains at or above the strike price, the put is “out of the money” and the option expires worthless. The premium paid for the put is then kept by the put seller, while the put buyer loses the entire investment.

Benefits of Sell-to-Open Put Options

Put options remain popular because they provide more options for investing and making money. One attraction for put buyers is the opportunity to hedge or offset the risk of an underlying stock’s price falling. Other reasons to use put options are as follows:

Reduce risk while generating a capital gain.

For example, an investor looking to profit from XYZ stock’s decline could buy just one put contract and limit the total downside to $500, whereas a short seller faces unlimited downside if the stock rises. The payoff for both strategies is similar, but the put position limits potential losses.

Make money from the premium.

Investors can generate income by selling options, which is a reasonable strategy in moderation. Selling puts can be an appealing way to generate incremental returns, especially in a rising market where the stock is unlikely to be put into the seller’s hands.

Increase the attractiveness of your purchase prices.

Put options are used by investors to obtain better buy prices for their stocks. They can sell puts on a stock that they want to own but cannot afford right now. If the price falls below the strike of the put, they can buy the stock and take the premium as a discount. If the stock stays above the strike price, they can keep the premium and retry the strategy.

Sell to Open Put Option vs. Calls Option

The other major type of option is a call option, which increases in value as the stock price rises. Traders can bet on a stock’s rise by purchasing call options. In this sense, calls are the inverse of put options, despite having similar risks and rewards:

  • Buying a call option, like buying a put option, allows you to earn many times your investment.
  • Buying a call option, like buying a put option, carries the risk of losing your entire investment if the call expires worthless.
  • Selling a call option, like selling a put option, earns a premium, but the seller assumes all risks if the stock moves in an unfavorable direction.
  • Selling a call option, as opposed to a put option, exposes you to uncapped losses (because a stock can rise to any price but cannot fall below $0). In either case, you risk losing many times the amount of the premium.

Sell To Open Vs Sell To Close

Even though the two terms sound similar, there are significant differences between “sell to open” vs “sell to close.” You must pay close attention when entering the orders to ensure that they are correctly entered.

Some of the distinctions are as follows:

  • A Sell to Open order allows you to short-sell a new option contract. Market participants buy and sell options contracts on a marketplace. Participants can either buy and sell an existing contract or create their own. A sell-to-close order, on the other hand, is used to sell an existing options contract that you already own, and it can be used for both call and put options.
  • A Sell to Open order allows you to create a new options contract (also known as “writing” a contract) that another options trader will purchase from you.
  • If the holder of the sell-to-open option chooses to exercise their right, you are obligated to sell them the security at the strike price, regardless of the actual price of the security. However, if you had a sell-to-close call option and the underlying stock price increased, you could hold it until expiration and exercise your right to buy the agreed-upon amount of underlying stock at the agreed-upon strike price.
  • There are various approaches to handling a sell-to-open order depending on whether it is a call or a put. However, for the seller to close, the contract’s value rises if the underlying stock’s price rises, and vice versa for put options.

When you write an option, you give the buyer the right, but not the obligation, to purchase the underlying security from you at a predetermined price (called the strike price).

Sell to Open Example

Assume trader XYZ believes the price of stock ABC will fall in the coming weeks. Then, on ABC’s call options, XYZ opens a sell-to-open position. This means that the trader is betting on ABC’s price falling and selling call options to the market maker, who is betting on ABC’s price rising. By taking a short position, XYZ can collect premiums on ABC’s call options.

Conclusion

A Sell to Open order is used by an options trader who wants to profit from a decrease in the contract’s value. The Sell to Open order generates a new options contract (known as a “write”), which is purchased by another trader.

A Sell to Close order is used to close a position for an option contract that you already own. You now understand the distinction between selling to open vs selling to close.

Frequently Asked Questions

Is sell to open bullish?

A Sell To Open order is one in which you sell a new option contract for a loss. This can be selling to open a call (bearish trade) or selling to open a put (bullish trade) (bullish trade).

How do you make money selling to open?

What Is the Best Way to Trade a Sell to Open Put Option? To make the strategy work, you must sell the option at a higher price and then buy the stock later at a lower price from your broker, retaining the profit if the market falls.

What happens when you sell to open an option?

A trader who sells to open opens a short position on an option. The opening allows the trader to receive cash or the option premium. The option’s call or put position can be covered, which means the option owner owns the underlying asset, or naked, which is riskier.

What happens if I don't exit option on expiry?

You are not required to fulfill the contract in the case of options contracts. As a result, if the contract is not acted upon before its expiration date, it simply expires. The seller forfeits the premium you paid to purchase the option. You are not required to pay anything else.

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