When trading options market participants have four different basic ways to place an open order or a close order.
Sell to Open (STO) is one of the two types of options open orders that can be used by an options trader to start a new trade. The other open order type is Buy to Open (BTO).
Sell to Open refers to the beginning of a short position, either a call or a put option. Any new options contract (call or put) that you have sold is considered a short option position.
Although not as straightforward as buying to open, selling to open is still a fairly simple concept to understand. To clarify, a short option position is different from stock short selling and has nothing to do with the direction in which you expect a specific stock (or the whole market) to trade.
The most crucial thing to keep in mind is that selling to open always establishes a new position. It never closes an option trade that is already open.
What is an Option?
There are only two types of options contracts: calls and puts.
A call option contract is an agreement in which an option buyer (holder of the call long option) gets the right (but not the obligation) to buy the shares of the underlying stock at a set price within a certain expiration date.
The option call seller (the option trader doing call writing) assumes the short position, getting an option premium from the option holder.
If assigned, the seller of the option, will have to sell the shares of the underlying security to the option buyer at the specified price (also known as strike price or exercise price) even if the price of the underlying asset is lower than the current market price.
On the other hand, a put option contract is an agreement in which an option buyer (holder of the long position) gets the right (but not the obligation) to sell the shares of the underlying stock at a specific price within a certain expiry date.
The option put seller (the stock market participant on the other side of the option contract) takes the short position, receiving an option premium (value of the contract) from the option holder.
In case of assignment, the put seller, will have to buy the shares of the underlying security from the option buyer at the specified price (strike price) even if that is higher than the share price on the open market.
Sell to Open a Long Call
Assume you own 100 shares of a certain a stock, and you believe the stock price will not rise much in the near future. As a result, you decide to sell a covered call in order to generate income from the shares.
To do so, you create a new position by selling to open a short call with a predetermined expiration date and strike price. When you sell to open a short option call, you receive a premium from the option buyer that is credited immediately to your brokerage trading account.
That position will remain open until one of three things occurs:
- at the expiration date, the underlying stock price is below the strike price, and the call option contract loses any time value, expiring worthless; in this situation, the option premium you initially received is yours to keep;
- at the expiration date, the stock price is above the strike price, and you get the option contract exercised and have to sell the 100 shares of the stock or ETF (for any option contract you sold) at the predetermined price;
- any time before expiration, you close the open short call position by buying back the option contract (this type of trading order is called Buy to Close).
Please note that selling a naked call option (not secured by the ownership of the shares of stock) will expose you to significant risk and potential unlimited losses.
Sell to Open a Long Call – Example
You own 100 shares of ABC stock that is currently trading at $50 per share, and you anticipate it will not make a significant move to the upside in the coming weeks. As a result, you sell to open a short call option with a strike price of $60 expiring in 45 days, paying a premium of $0.50 per share ($50 for each option contract excluding commissions).
Because the stock price is trading below the strike price when you buy to open the position, the option price is entirely made up of time value (extrinsic value), while the intrinsic value is equal to zero. The short call option is referred to as being out-of-the-money (OTM).
First Possible Alternative
The stock is trading at any price below the strike price on the expiration date. In this situation, the call option expires worthless, and you will keep the whole premium received to start the option contract. As expiration approaches, all of the extrinsic value included inside the option price decreases until it reaches zero due to the time decay effect.
Second Possible Alternative
At expiry, the stock is trading at a higher price than the strike price, making it in-the-money (ITM). In this case, too, any time value in the option price is zero. The intrinsic value, on the other hand, is positive, and it is calculated by subtracting the strike price from the stock price on the expiration date.
For example, if the stock is currently trading at $70, the option price at expiration would be $70 (stock price) minus $60 (strike price), which equals $10. After deducting the $0.50 premium per share received to initiate the position, you have a net loss of $9.50 per share, or $950 for every existing contract (excluding brokerage transaction costs).
In this instance, you have the option of letting the option expire and being exercised. This means that you will sell 100 shares of ABC stock (for every options contract you possess) at a strike price of $60, even though the stock is currently trading at $70 per share on the open market.
As an alternative, you can decide to buy to close the short call position for a loss just before expiration at a price close to $10 per share. At that time, the option price will be mainly determined by the intrinsic value, as the extrinsic (time value) will be close to zero.
In this case, the loss on the short call position will be compensated by the rise in the price of the shares of the stock you own.
Third Possible Alternative
You can buy to close the short call option contract at any point before expiration, regardless of whether the stock price is trading below or above the option strike price.
Of course, if the stock price is lower of when you opened the position, the option price has most likely decreased, allowing you to close the position for a profit. This is related to the time decay effect, which erodes an option’s extrinsic value with the passage of time.
On the other hand, if the stock price has risen since your entry price, the option price may have risen as well. In any case, other factors, such as the change in the implied volatility (IV) in the option contract for that specific expiration, may have an impact on the overall option price.
Sell to Open a Long Put
Assume you believe a stock will not decline significantly in a short period of time. As a result, you decide to sell a short put to profit from the move.
To do so, you establish a new position by selling to open a short put with a fixed expiration date and strike price. When you sell to open a short option put, you receive a premium from the option buyer that is credited immediately to your brokerage trading account.
The short option is a naked put in case the put seller does not have the collateral to secure the purchase of the shares of the stock in the event of assignment. On the other hand, the short option is referred to as a cash-secured put in case the option writer has enough funds to buy the shares of the stock if assigned.
The position will remain open until one of three things occurs:
- at the expiration date, the price of the underlying security is above the strike price, and the put option contract loses any time value, expiring worthless; in this situation, the option premium you initially received is yours to keep;
- at the expiration date, the stock price is below the strike price, and you get the option contract exercised and have to buy the 100 shares of the stock or ETF (for any option contract you sold) at the predetermined price;
- any time before expiration, you close the open short put position by buying back the option contract (this type of trading order is called Buy to Close).
Sell to Open a Long Put – Example
Stock XYZ is currently trading at $100 per share, and you anticipate it will not make a significant move to the downside in the coming weeks. As a result, you sell to open a short put option with a strike price of $90 expiring in 45 days, receiving a premium of $1.00 per share ($100 for each option contract excluding commissions).
Because the stock price is trading above the strike price when you buy to open the position, the option price is entirely made up of time value (extrinsic value), while the intrinsic value is equal to zero. The put call option is referred to as being out-of-the-money (OTM).
First Possible Alternative
The stock is trading at any price above the strike price on the expiration date. In this situation, the call option expires worthless, and you will keep the whole premium received to start the option contract. As expiration approaches, all of the extrinsic value included inside the option price decreases until it reaches zero due to the time decay effect.
Second Possible Alternative
At expiry, the stock is trading at a price lower than the strike price, making it in-the-money (ITM). In this case, too, any time value in the option price is zero. The intrinsic value, on the other hand, is positive, and it is calculated by subtracting the stock price from the strike price on the expiration date.
For example, if the stock is currently trading at $80, the option price at expiration would be $90 (strike price) minus $80 (stock price), which equals $10. After deducting the $1.00 premium per share received to initiate the position, you have a net loss of $9.00 per share on the open put option, or $900 per contract (excluding brokerage commissions).
In this case you have the alternative of letting the option expire and being exercised. This means that you will buy the 100 shares of XYZ stock you possess at the strike price of $90, even though the stock is currently trading at $80 per share on the open market.
As an alternative, you can decide to buy to close the long put position for a loss just before expiration at a price close to $10 per share. At that time, the option price will be mainly determined by the intrinsic value, as the extrinsic (time value) will be close to zero.
Third Possible Alternative
You can buy to close the long put option contract at any point before expiration, regardless of whether the stock price is trading below or above the option strike price.
Of course, if the stock price is higher of when you opened the position, the option price has most likely decreased, allowing you to close the position for a profit. This is related to the time decay effect, which erodes an option’s extrinsic value with the passage of time.
On the other hand, if the stock price has fallen since your entry price, the option price may have risen. In any case remember that other factors, such as the change in the implied volatility (IV) in the option contract for that specific expiration, may have an impact on the overall option price.