When traders initiate a new short options trade, they use an order called sell to open. A sell to open order creates a short options trade. It can be used with call and put options and for both naked or covered options.
What is a Sell to Open Order?
A sell to open order is an options trading order that initiates a short position. It is one of the four basic options trading order types. It can be used for both calls and put options.
Although a sell to open order can be used for other derivatives too, it is usually associated with options trading. A sell to open order is used to open a short position on an options contract. A trader would then use a buy to close order to close the short position opened with this order type.
How Does a Sell to Open Order Work?
A trade can take a long or a short position with options trading, meaning it can buy or sell (write) an options contract, depending on the trading strategy. A sell to open is the order type that creates a short position on an options contract. Meaning that the trader is writing an option, or selling it to someone going long that options contract.
The premium on taking a short position is paid by the other investor who anticipates the opposite movement in the underlying asset’s price.
The seller with the sell to open order anticipates a price movement below or the above the strike price, depending on if it is a call or a put.
The seller can write call or put options or a combination of both types of options contracts to balance the investment portfolio and the associated risks.
When a trader creates a short position on a call option, it uses a sell to open order. If a trader is bearish on a stock, going short on a call option is one of the possible trading strategies. The trader would receive a premium by selling the options contract.
The trader would keep the premium on a short call if the price of the underlying asset remains below the strike price.
Traders who short a call can use naked or covered call options. A covered call is used when a seller already owns the shares of that option. As it reduces the risk for the seller. However, if the trader is selling a naked call option, and the underlying asset’s price moves above the strike price, the seller of a short call can face unlimited loss. This is because the buyer can exercise the option. Meaning the seller will have to sell the underlying asset to the holder. If the options contract is exercised for the strike price agreed.
A short put option works exactly the opposite way as a short call option. The seller initiates a short put with a sell to open order. A short put is another risky endeavor that only advanced traders should undertake.
Thus, the seller of a short put will benefit if the underlying asset’s price moves upwards. The profit of the short put seller is limited to the premium received from the buyer. However, if the price moves downwards, the buyer of the short put benefits.
Similar to a short call, the seller of a short put can use both a naked or a covered put option. A covered put option with shorting stocks, selling a put, or buying a short call option to minimize the risk.
If the seller of a short put wishes to close the order or exit the trade position opened through a sell to open, the offsetting trade order will be a buy to close.
Buy to open
Both of these orders open or initiate a new trade position with options trading. When a trader initiates a new long call or put option, the order type used is called buy to open order. Similarly, when a trader creates a short call or put option trade, the order used is called a sell to open.
A sell to close order is the exit order used for a buy to open order. Whereas, a buy to close order offsets the selling or writing of an option. Here are the main differences between sell to open vs sell to close.
Image source: Unsplash