Investment Tips 18-04-2023 21:30 16 Views

Sell to Open vs Sell to Close

(We have similar post on the opposite trade: Buy To Open vs Buy To Close)
 

What Is Sell to Open In Options Trading?

An open position means that you’re entering a trade when you place an order. Selling to open means you are selling an options contract to open a position.

 

You need to use a sell-to-open order whenever you want to open a new short call or short put.

 

Let’s put this into real terms. Imagine you want to sell a call option where the underlying stock is trading for a $1.30 premium and the expiry date is two months in the future.

 

Let’s say the current stock price is $50 with a strike price on the call of $55. To sell this call option through your brokerage, you would need to use a sell-to-open order.

 

When the time comes to exit the position, you’ll need to use a buy-to-close order.

 

You can do this at any time — even the day after you use the sell-to-open order. In the above example, you may choose to buy to close if the underlying stock price increases to perhaps $57 before it reaches expiry date. When you use a buy-to-close order, the open short option position becomes closed.

 

Bear in mind that a sell-to-open order may not always execute. This can happen when an exchange limits to closing orders only during certain market conditions. One example of such a market condition is when the underlying stock for the option you are trying to sell to open is scheduled for delisting. Another reason could be that the exchange will not be trading the stock for some time.
 

 

What Is Sell to Close?

As you saw above, sell to open (and buy to close) applies to short calls and puts. For long positions, you have sell to close (and buy to open). In other words, you need a sell-to-open order to establish a new position with short calls and puts.

 

To be able to sell to open, you need collateral for the position. This can be in the form of the corresponding stock shares or the equivalent value in cash. In the case you have the shares, you’ll be sharing a covered position. If you don’t have shares, you are shorting the option or selling a naked position.

 

Then, as we have seen, when you want to close the position, you’ll need to use a buy-to-close order.

 

Selling to open is simple enough. Let’s look in greater detail at what we mean by selling to close.

 

First, you need to remember that, in options, buying long means buying a contract from an options writer. Your aim is to see the underlying stock price rise (for calls) or fall (puts), which will bring you a profit when the trade closes.

 

The trade will end when it reaches maturity, with you selling the position. You will make a profit if the sold price is more than the bought price.

 

When you sell to close, you exit a short position that already exists. Put another way, you have an open position for which you have received net credit. By writing that option, you are closing that position.

 

Sell to Open vs Sell to Close: When to Use Each

Now that you understand the difference between sell to open and sell to close, all that’s left is to be clear about when to use them.

 

When Should Investors Sell to Open?

Whenever you want to sell a call or put to benefit from a change in price of an underlying asset, by receiving options premium, you can sell to open. 

 

When Should Buyers Sell to Close?

As an option buyer, time decay is in not in your favor. All the same, there may be times when you’ll want to close the position before it expires.

 

One instance of when this could be true is in the case of a price change in a favourable direction to the underlying asset. When this happens, selling to close may enable you to access profits earlier.

 

For example, imagine you have purchased at-the-money calls that last 3 months. Then, after two months, the underlying asset increases by 30 percent. You could use the opportunity to sell to close and access the majority of your profits immediately before time decay hits.

 

Alternatively, selling to close could reduce your potential losses. Let’s return to the same scenario above of buying at-the-money calls.

 

However, this time, instead of the underlying asset increasing by 30 percent, let’s say it decreases by that amount. You could decide to sell to close at this point to avoid even greater losses that you may incur by waiting longer.

 

The key rule of thumb for deciding whether to hold on to an existing position is, “would I put this position on from scratch”. If the answer is yes, keep holding on to the trade; if not, close it.

 

Long and Short Options in the Same Position

Some option spread strategies allow you to carry both a long option of an asset and a short option of an asset at the same time. This is useful for giving you the opposite position without needing to close the original open position. In other words, you gain when the underlying asset price moves in the right direction, but you also reduce risk compared to just selling a single option.

 

Whereas you could sell your long and short options separately, if you’re using a brokerage that specializes in options, the chance is you can enter the strategy as a single trade.

 

So, when you have a strategy that contains multiple long and short options, what should you use? Should you sell to open (and sell to close) or sell to close (and sell to open)? The answer is: it depends.

 

For strategies like a bull put spread, bear call spread, short straddles, and short strangles, you’ll use sell-to-open orders. This is because you open these strategies with net credit, meaning you are receiving premium to open the position. You’ll also use sell-to-close orders — it’s just like with long positions.

 

Deciding when to sell to open and sell to close sounds simple enough. However, like everything in options trading, it does involve some calculating to predict how the price of the underlying asset is likely to change.

 

This is further complicated when you have an option strategy that includes both long and short options. In these cases, you’ll need to consider your overall position to ensure you make the right decision.

About the Author: Chris Young has a mathematics degree and 18 years finance experience. Chris is British by background but has worked in the US and lately in Australia. His interest in options was first aroused by the ‘Trading Options’ section of the Financial Times (of London). He decided to bring this knowledge to a wider audience and founded Epsilon Options in 2012.

 

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