In options trading, investors deal in contracts to buy and sell stocks at a specific price within a limited period. Options are available on many stocks, as well as some exchange-traded funds.
Brokers and financial managers must perform due diligence on customers interested in trading options. That usually means investors must request options trading permission from their brokers or online trading platforms.
“Sell to open” is an instruction to sell or short an option to open a transaction, while “sell to close” means the reverse: closing a transaction by selling an option purchased for the account.
Sell To Open and Sell To Close
Options trading entails some obscure terminology. One essential concept traders should learn about this market is “sell to open” vs. “sell to close.”
What Does ‘Sell To Close’ Mean?
Sell to close means selling an option previously bought to open the transaction. This closes the position.
Sell to close can result in a profit, but can also leave the trader with no gain or even a loss, depending on the value of the position when they sell compared to the value when they purchased it.
When Should You Sell To Close?
Once the option has gained value to the target price, the trade is profitable.
However, if the option is losing money and it seems that it will continue to do so, it may be a good idea to sell to close to mitigate losses. It’s important to understand the market and avoid any panic-selling, however.
What Does It Mean To ‘Sell To Open’?
Options can be sold to begin a transaction. The cash from the sale is added to the account, reflecting a short position until the option is bought, expires or is exercised.
What Is the Difference Between ‘Buy To Open’ and ‘Sell To Open’?
Buy to open indicates a “long” position in which the trader holds the option in the account and seeks to profit from a rise in the option’s value. Sell to open is the opposite, in which the trader collects cash from a sale and waits for the option to lose most or all of its value.
Time Value and Intrinsic Value
The value of an options contract varies with the price of the stock, the time to expiration and other factors. The longer the time to expiration, the more “time value” an option has. And generally, the more volatile the stock, the higher the option’s premium.
Option value also varies with the underlying stock’s price. Depending on this price, an option may have intrinsic value. For example, an option to buy an AT&T option for $10, when the market price of AT&T stands at $15, has an intrinsic value of $5. If AT&T is lower than $10, however, there’s no intrinsic value, only a time value that decreases as the expiration date approaches.
Short Trading Options
Call options are contracts to buy a stock, while put options are contracts to sell. A trader can begin the options trade by either buying — “going long” — or selling — “going short.” One can buy or sell a call or put.
When shorting, the trader instructs their broker or trading software to “sell to open.” The word “open” in this case means opening or beginning the trade.
Once a short trade occurs, the trader’s account is credited with the premium or option price earned from the sale. Note that options contracts are denominated in 100 shares of a given security. Selling to open an options contract with a premium of $1 earns the trader $100 cash.
The Option Lifecycle
As the option’s expiration date approaches, its value may change. If the stock rises, a call option will also increase in value. A put option on this stock would lose value.
An underlying stock falling in price will lessen the worth of a call option and increase the value of a put option.
If an investor buys a stock option, they can sell it for the market price up to expiration. This would close the option transaction, so the broker or the online software instruction would be “sell to close.”
An investor can also exercise the option, meaning they buy or sell the stock for the option’s strike price. For example, holding a $25 AT&T call option allows an investor to buy AT&T for $25 a share at any time up to the option’s expiration.
When an investor sells to open, they take a short position in an option. There are three possible results: they can buy the option to close the transaction, the option may expire or the option may be exercised.
If the stock price remains lower than the option’s strike price on the expiration day, the option will expire worthless. An option to buy something for a price higher than the market price has zero value. The investor’s short position has profited since they collected money at the open and paid nothing at the close of the trade.
The option has intrinsic value if the stock price is higher than the strike price. If the investor does nothing, the option will be exercised and the stock will be called away or “assigned.” If the investor shorted one option and owns 100 shares of the stock, they have a “covered” call option. Their broker will sell the investor’s stock at the strike price, and the investor will collect the proceeds from this sale and the funds earned at the trade open.
However, if an investor doesn’t own the stock, they take a “naked” short position. They’ll have to buy the stock for the market price, then sell it for the option strike price.
Dangers of Options Trading
Options attract many investors, but trading them requires knowledge of how the stock and options markets operate.
When “going long,” the investment in an option contract will be much less than in a stock. Options also offer leverage: a cash outlay of a few hundred dollars can return several hundred percent to the investor if the option price moves in the right direction.
But options are also riskier than stocks. The time decay of an option means traders have much less time for the price to move. Also, the price has to move fast and far to overcome the spread charge, which is the difference between the buying price and the price at which the investor can sell the option.
To help navigate the risks of trading options, new traders should thoroughly research how leverage, time decay and other factors can work against them. An online or retail brokerage also may offer practice accounts, where traders can experiment with fake money to understand how different options trades work out.