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Sell to Open

The process of initiating a short options position

What is Sell to Open?

Sell to open is an options trade order and refers to initiating a short option position by writing or selling an options contract. When an individual sells to open, he/she is initiating a short options position. It is useful to think of a sell to open as “opening an options contract by writing or selling.”

 

Understanding Sell to Open

An options contract is defined as an agreement between two parties for a potential transaction of the options contract’s underlying asset at a predetermined price (the strike price) on or before an expiration date. The two types of options are call options and put options.

 

Two Types of Options

For each type of options contract, one party is long, and one party is short:

 

1. Call Option

The party with a long position BUYS the call option and believes that the underlying asset’s price will increase. A premium is paid for the right to purchase the underlying asset at a predetermined price (the strike price) on or before an expiration date.

The party that has a short position SELLS the call option and believes that the underlying asset’s price will decrease. As such, this party is opening an options contract by selling (sell to open) the opportunity to purchase the underlying asset at a predetermined price on or before an expiration date for a premium.

 

2. Put Option

The party with a long position BUYS the put option and believes that the underlying asset’s price will decrease. A premium is paid for the right to sell the underlying asset at a predetermined price (the strike price) on or before an expiration date.

The party with a short position SELLS the put option and believes that the underlying asset’s price will increase. As such, this party is opening an options contract by selling (sell to open) the opportunity to sell the underlying asset at a predetermined price on or before an expiration date for a premium.

 

The following graphic illustrates sell to open:

 

Sell to Open - How It Works

 

Option Premium From Sell to Open

When a party sells to open an options contract, a premium is received. The premium reflects the current market price of the options contract. The options premium is a combination of two factors – extrinsic and intrinsic value.

 

Option Premium

 

Extrinsic value is based on (1) time value – the time remaining until the option contract expires, and (2) implied volatility – the amount that the underlying asset may move.

  • The more time until an options contract expires, the greater the time value and resulting extrinsic value. The greater the time to maturity, the greater the probability that the underlying asset will surpass the strike price.
  • The more volatile the underlying asset is of an options contract, the greater the extrinsic value. Again, it is because it increases the probability that the underlying asset will surpass the strike price.

 

Intrinsic value reflects how much the options contract is “in the money.”

  • A call option has intrinsic value when the underlying asset’s price is above the strike price.
  • A put option has intrinsic value when the underlying asset’s price is below the strike price.

 

Example of Sell to Open and Option Premium

Question: Tim thinks that Company A’s stock price will decrease in the near future. What type of options contract and type of trade order would be appropriate to profit from this speculation?

Answer: Tim should initiate a sell to open trade order on call options of Company A.

 

Question: A call option comes with a strike price of $50. The underlying asset is priced at $45. However, the premium is currently $5. Where is the premium coming from?

Answer: For a call option, if the underlying asset’s price is below the strike price, there is no intrinsic value. The option premium is coming entirely from extrinsic value, namely, time value and implied volatility.

 

Key Takeaways

  • Sell to open refers to initiating a short options position.
  • The premium generated from sell to open is based on intrinsic and extrinsic values.
  • When an investor sells to open a call option, he/she believes the value of the underlying asset will decrease. On the other hand, when an investor sells to open a put option, he/she believes the underlying asset’s value will increase.

 

Additional Resources

CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

  • At the Money (ATM)
  • Intrinsic Value
  • Options: Calls and Puts
  • Long and Short Positions

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