What's the difference between sell to open vs sell to close?
To be a successful options trader, you must educate yourself about every aspect of options trading.
An essential part of learning options trading involves properly and effectively opening and closing trades.
When you trade options, there are four primary ways to set up your trade:
- Buy to Open - Buying an options contract to open a trade.
- Sell to Close - Selling an options contract to close a trade.
- Sell to Open - Selling an options contract to open a trade.
- Buy to Close - Buying an options contract to close a trade.
The difference between sell to open vs sell to close features two aspects of options trading that have their own benefits and drawbacks, so it's important to understand the difference between them.
In this article, we'll look at the two methods in more detail so you can make the best decision in developing your own trading strategy.
Sell to Open vs Sell to Close: Why is it Important?
The science of options trading is simply maximizing your profits and minimizing your losses.
If you own stocks, then learning how to trade options is a fantastic way to generate additional income from assets you already own while also creating a solid hedge against potential losses.
When you sell to open, you are opening an options trade and collecting a premium.
You have to buy to close if you do not let it continue to the expiration date.
When you sell to close, you are closing a trade and collecting an amount that hopefully is more than you originally paid when you entered a buy to open trade.
There are a few more differences that we will cover in this article. When you fully comprehend all of the differences between sell to open vs sell to close, you are two steps closer to creating a solid trading plan and accomplishing these goals under almost any market condition.
Sell to Open vs Sell to Close: What is Sell to Open?
Selling to open means that you are opening a new position by selling an option contract.
This is often done when you believe the underlying asset's price will go down.
When you sell to open, you are essentially selling the right to buy the underlying asset at a specific price (the strike price) at some point before the expiration date.
The money that you collect is called the premium.
Using this strategy, you collect the premium when you open the trade. If you want to close this trade before the expiration of the contract, you will execute a buy to close order using the premium you collected when you opened the trade.
The difference between the premium you collected, and the price you have to purchase the option, is your profit.
Additionally, if the option expires worthless, you keep the entire premium you received when you opened the trade as your profit.
Advantages of Selling to Open
- You collect a premium upfront when you open a trade.
- You can create an additional income stream from assets you already own.
- The options can be used to hedge against downside risk in a portfolio (referred to as covered calls or covered put options).
Disadvantages of Selling to Open
- It may be difficult to exit the trade when the underlying asset price is aggressively moving against you.
- There is a potentially unlimited financial risk if the market moves against the position. These types of trades are referred to as naked calls and naked put options.
Example of a Sell to Open Options Trade
A sell to open options trade is when you sell a call or put option contract in order to open a position.
This is generally done to take advantage of an expected price move or hedge against downside risk.
For example, a trader is bullish on stock XYZ and expects it to rise in the next month.
They could sell to open using a put option. If XYZ's stock price increases, the put option will decrease in value.
Also, as the time to expiration continues to get closer, time decay will significantly impact the price drop of the option.
The trader can close the trade and take a percentage of the profits early.
Alternatively, they can hope the trend continues, which would make the option worthless, allowing the trader to keep the entire premium as profit.
However, if the stock price does indeed fall, the option price will increase.
The trader will have to decide if they want to buy the put options contract to close the trade early and minimize their losses or if they want to hold on longer, hoping that the price will begin to increase before the expiration of the options contract.
Unfortunately, if the option contract expires while the price is going down, the loss on the trade will be far more than the premium collected when the trade first opened.
For some traders, it only takes a handful of poorly managed trades to destroy their entire options trading account.
Sell to Open vs Sell to Close: What is Sell to Close?
Selling to close means that you are closing an existing position by selling an option contract.
This is often done when you believe the underlying asset price will go up.
When you sell to close, you are selling the contract to purchase an underlying asset at a particular price (the strike price) before the expiration date.
When using this strategy, you buy the contract to open the trade, and if you are correct about the trade, you will receive your profits when you sell to close.
If the option price has increased, the difference between the initial option price and what the contract is sold for is your profit.
Advantages of Selling to Close
- Maximum losses are limited to the initial amount paid to open the trade.
- You can limit losses or take profits early at any time prior to the expiration of the contract.
- Avoids extra trading commissions by selling to close before exercising the option contract(s).
Disadvantages of Selling to Close
- You may limit your profits if you sell too early and the underlying asset rallies sharply afterward.
- You miss out on the opportunity to acquire shares of the underlying asset at a potentially desirable price.
Example of a Sell to Close Options Trade
The trader must sell their option contract to another party to close an options trade. The trade will be closed at the current market value of the contract.
For example, let's say a trader believes the price of an underlying asset will decline. They would buy a put option on XYZ stock with a strike price that is now below the current price of the stock.
Since the current market price of XYZ stock has fallen, the trader may want to take their profit.
The trader would simply sell their put option contract to close the trade.
The profit is the difference between what the trader initially paid and the price for which it was later sold.
However, suppose the price of the underlying asset increases prior to expiration. In that case, a trader will have to decide if they want to sell early and minimize their losses or if they want to hang on longer in hopes that the market will turn in the other direction.
If the option contract reaches expiration, the trader will have lost their entire investment used to open the trade.
Sell to Open vs Sell to Close: Tips for Successful Trading
Understanding the trading concepts we have covered today is not enough to become a successful options trader.
Before focusing on the details of the sell to open vs sell to close debate, you must be aware of some vital aspects before entering these trades.
We will cover a few below, but ensure you fully comprehend them and how they may impact any option trading strategies, you may use.
Probability of Success
Many brokers offer tools that automatically calculate your likelihood of success before entering a trade.
The higher the probability, the lower the potential profits.
The lower the probability of success, the higher the potential profits if you end up in a winning trade.
Time decay is the amount by which the value of an option declines over time. It is a function of how close the option is to expiration.
The closer it is to expiration, the faster it will lose value.
Time decay works in your favor if you sell options (known as writing options).
That's because you receive a premium up front when you sell an option, and that premium will slowly erode over time as the option approaches expiration.
On the other hand, time decay works against you if you are buying options.
That's because you have to pay a premium upfront when you purchase an option, and that premium will slowly erode over time as the option approaches expiration.
One of the most important things to understand about implied volatility is that it can significantly impact the price of options contracts.
In simple terms, implied volatility is a measure of a security's expected price movement over a given period.
Implied volatility looks forward and tries to predict how volatile a security will be in the future.
When implied volatility is high, option prices will typically be higher.
This is because there is a greater chance that the underlying security will make a big move during the life of the option contract.
Several different factors can impact the level of implied volatility in a security.
These include earnings announcements, economic data releases, and geopolitical events.
Intrinsic value is the amount by which an option is in-the-money.
It is the difference between the underlying asset's price and the strike price of the option contract.
If the underlying asset is trading at $50 per share and a call option has a strike price of $45, then the intrinsic value of that option is $5.
Extrinsic value is the portion of an option's price that is not attributable to its intrinsic value.
It is also known as time premium because it declines as expiration approaches and eventually expires to zero on the expiration date.
Time decay accelerates as expiration gets closer.
In The Money Options
Being "in the money" means that your option has intrinsic value because the underlying security's price is above (for a call) or below (for a put) the strike price.
An option not in the money has no intrinsic value but may still have extrinsic value.
Out Of The Money Options
Out of the money options are options with strike prices that are higher than the current market price for call options or lower than the current market price for put options.
If you were to exercise your option immediately, you would incur a loss.
However, out of the money options can still be profitable because they often have a lower premium than in the money options.
This means that you may be able to sell your option for a profit even if it never reaches its strike price; it simply needs to get closer.
The Bottom Line: Sell to Open vs Sell to Close
The bottom line is that there is no right or wrong answer regarding the debate between sell to open vs sell to close.
It all depends on your opinion of the market.