Options trading has become a more popular way to increase potential returns and diversify assets. Trading options is more complicated than stock trading, as you will have to understand the difference between selling to open and selling to close. Both of these choices will show up in your options trading app. They help traders realize profits and minimize losses. Understanding how these sell orders work can help you feel more comfortable with having options in your portfolio.
4 Ways to Set Up an Options Trade
Every options trader has four ways to set up options trades. They are as follows:
- Buy to open
- Buy to close
- Sell to open
- Sell to close
This article will cover sell-to-open and sell-to-close orders. Both of these sell orders involve selling options contracts, but each order has a different objective.
What is Sell to Open?
A sell-to-open order initiates a new position in your portfolio. It’s the foundation for options trading strategies that focus on cash flow.
How Sell to Open Works
Sell to open is essentially shorting a call or put. Traders who sell to open want the asset’s value to decrease and eventually become worthless. The requirements to establish a sell-to-open order depend on the setup. Traders looking to sell covered calls need to own 100 shares of a company before they can sell a call to open a new position. Uncovered calls and puts do not require that you have cash or shares in advance.
Advantages of Sell to Open
Using sell-to-open orders can provide several advantages. You can increase cash flow from long-term assets by selling out-of-the-money covered calls. Selling to open can also help you purchase stocks at a discount. Some traders sell at-the-money puts to collect a premium and get 100 shares if the stock price is below the strike price at expiration.
Things to Remember
Any market order has the potential to lose money, and sell-to-open orders are no exception. An options contract can significantly rise above the price you sold it at. Under this scenario, you can either buy to close at a loss or wait for the buyer to exercise the option. In the case of a covered call, your shares may get assigned, and this situation can trigger additional capital gains if you have been holding onto the shares for a while. Continuing to learn about options trading can help you feel more confident with starting and closing positions.
Example
Covered calls are a popular way for dividend investors to increase cash flow with options. Suppose a dividend investor owns 100 shares of a company valued at $50 per share. The investor already receives an annualized $2 dividend, resulting in a 4% yield. The investor can turn that 4% yield into a 5% yield with a sell-to-open order for a covered call. During this order, the investor sells a call with a $55 strike price for a $1 premium. This investor assumes the stock will not reach $55 per share until after the expiration date. The annualized $2 per share in cash flow now becomes $3 per share if you include the premium. A 4% yield turns into a 6% yield. If the stock is above $55 per share at expiration, the investor will have to part ways with the 100 shares at $55 per share, regardless of the current market price.
Sell to Close
Sell to close is another important options trading order that involves exiting a position you have established. Many investors have already used sell to close for their portfolios. If you bought a stock and sold it a few months later, you initiated a sell-to-close order, even though you only saw the word “sell” when you made the transaction.
How Sell-to-Close Works
Sell to close only works with existing positions. You had to buy a call or put to open the position. When you feel like selling, whether it’s to secure a profit or protect yourself from further downside, you initiate a sell-to-close order.
Advantages of Sell to Close
Sell to close can help you lock in gains or avoid further losses. Those are the primary reasons people sell to close. Locking in gains can prevent you from losing them from sharp price swings. Those price swings come with the territory of options trading. Some traders prefer securing a 20% gain rather than hoping an options contract will generate a 50% gain in a few days.
Things to Remember
When you sell to close, you leave the position for good, but this move can trigger fear of missing out (FOMO). Some options traders who make the less risky play and exit the position watch as the option doubles in value while sitting on the sidelines. This scenario can be frustrating, and some traders engage in revenge trading in an attempt to sort this out. This emotional response to seeing yourself miss out on gains can result in riskier trades and options taking up more of your portfolio than they should. Selling to close can also result in a lot of capital gains if you make a big profit, but it’s better to have a lot of capital gains to worry about than tax write-offs from capital losses.
Examples
Suppose a trader discovers a stock priced at $70 per share. This trader believes the stock can quickly go up to $80 per share and purchases a call with an $80 strike price set to expire in two months. The trader pays a $3 premium for this call contract. This purchase is considered a buy to open the position. The only three endings to this story are exercising the option, letting it expire worthless or selling the contract to close the position.
The breakeven price is $83 since it reflects the sum of the strike price value ($80) and the premium ($3). If the stock trades at $83 per share at expiration, the position is breakeven. If the stock only goes from $70 to $75 per share, the option will expire worthless. Some traders in this scenario sell to close to cut their losses. The position would have been briefly profitable if the stock rose from $70 per share to $75 per share within a few days of purchasing the contract. If you sold to close then, you would have made a profit.
If the stock goes from $70 per share to $100 per share during those two months, you will record a significant profit from your call contract, assuming you held onto it. You can sell to close or wait for the contract to get exercised. You will need enough money in your brokerage account to purchase 100 shares at the strike price if you want it to get exercised.
Open First and Then Close
Most options trades start with someone opening a position and then closing it at the right time. The main exceptions are expiration or the contract getting exercised. Understanding how sell-to-open and sell-to-close orders work can help you become a more effective options trader and master various strategies. Building this foundational knowledge will help when it comes to starting your options trading journey.
Frequently Asked Questions
Is sell to open bullish or bearish?
It depends on what contract you sell to open. Selling a call to open a position is bearish while selling to open a put is bullish.
When should you sell to open?
You should sell to open to generate additional cash flow. Covered call sellers usually want their contract to expire worthless while some put sellers want to buy 100 shares, but at a discount.
When should you sell to close?
You should sell to close to secure profits or minimize your losses. You should assess your risk tolerance, portfolio goals and convictions about the position before selling to close.
About Marc Guberti
Marc Guberti is an investing writer passionate about helping people learn more about money management, investing and finance. He has more than 10 years of writing experience focused on finance and digital marketing. His work has been published in U.S. News & World Report, USA Today, InvestorPlace and other publications.