What is Sell to Close?
Sell to close is an options trade order and refers to closing out (selling) a long position in an options contract.
Understanding Sell to Close
A long options contract comes with three outcomes:
1. The options contract expires worthless.
In long call options, it occurs when the underlying asset’s price expires below the strike price.
In long put options, it occurs when the underlying asset’s price expires above the strike price.
2. The options contract is exercised.
- In long call options, it occurs when the underlying asset’s price is above the strike price and the option is exercised.
- In long put options, it occurs when the underlying asset’s price is below the strike price and the option is exercised.
3. The options contract is sold (sell to close) on the market before expiry.
When an investor sells to close an options contract, he/she is selling the contract to another market participant. Depending on the contract’s value at the time of execution, a sell to close trade order can generate a profit or loss for the investor.
Example of Sell to Close
Question: Tim currently holds a long European-style call options contract on Apple stock valued at $1,000. The contract expires in one month. Tim would like to realize a profit on the contract, but due to the call options contract being European-style, it can only be exercised on the expiration date. What suggestion would you give to Tim such that he can realize a profit on the options contract?
Answer: Tim could sell to close the long call options contract on the market. In doing so, he is selling the contract to another party and is able to realize a profit (somewhat discounted) immediately.
Sell to Close or Exercise an Options Contract?
Given an in-the-money options contract, a common question is whether to exercise the options contract or sell to close.
In reality, the majority of options traders choose to sell an in-the-money options contract rather than exercise it. The primary reasons being:
- To avoid extra commissions involved with buying the underlying asset and subsequently selling it in the open market.
- To avoid the risk of spillage, which is defined as receiving a different price than expected from selling a stock on the open market. Spillage is likely to occur when the underlying asset has high volatility and low volume.
- To retain extrinsic value on the options contract. Exercising the options contract would only generate the intrinsic value for the contract holder while selling the options contract would generate the extrinsic and intrinsic value.
The two main factors that affect extrinsic value are:
- Time to expiration: An option with a longer time to maturity would come with a greater extrinsic value.
- Implied volatility: An option whose underlying asset is more volatile would assume a greater extrinsic value.
- Sell to close refers to closing out a long position in an options contract.
- There are three outcomes with a long options contract: (1) it expires worthless, (2) it is exercised, and (3) it is sold.
- The majority of option holders choose to sell a long options contract rather than exercise it. It is to (1) avoid extra commissions, (2) avoid the risk of spillage, and (3) retain extrinsic value.
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