Sell to Open: A Guide to the Short Side of Options Trading
In all of my prior articles on trading options, the examples have been based on buying an option, whether it is a call option or a put option.
In this article, the sale or “writing” of an option is going be discussed.
The terminology to initiate the purchase of an option is called “buy to open”. This is true for the purchase of either a call or a put. The opposite side of this transaction is executed by the option seller as “sell to open” or “sell to close”
As a buyer of an option, the underlying process being discussed is transparent. The explanation is designed to help understand the process of being a “writer” of an option contract.
If the option is being bought is marked “sell to close”, than the transaction took place from an existing pool of contracts. How does the pool of contracts come into existence?
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Options have the characteristic of being created in an “opening” transaction. This means that an option contract is created “on demand”. At the time that a buyer appears to purchase an option contract, if there are no contracts available in the existing pool, a new contract is “written” by the seller of the option contract. This transaction is marked as “sell to open” by the seller. This transaction will also be noted as an increase in the “open interest” in the option series. Before the computer, the contract was written by hand. Hence the term of “writing” an option. In the computer age, the transaction and relevant information is stored in a computer, but the term “writer” is still used today.
These opening transactions are done thousands of times a day. The mechanics of these transactions are handled by the option exchanges and the entire process is overseen by the Options Clearing Corporation.
In many cases, the options are written by options market professionals know as market makers. Writing options is part of the role of market makers at the option exchanges. These firms specialize in being the buyers and sellers of the options as the order flow dictates, and understand all facets of the options market.
This does not mean that the retail trader and investor can not be involved with writing options. In fact, one of the uses of options to create income involves being involved in “writing” options.
There are some unique risks involved in writing options. It is important to understand the risks and rewards of taking the “sell to open” side of the transaction. (Another term for selling or writing an option, by the way, is to be “short” the option.)
The seller of an option takes on an obligation under the terms of the option contract. In the case of writing a call option, the writer has the obligation to deliver the underlying stock to the buyer of the call option if the stock price is above the strike price at expiration
For example, a decision is made to sell (write) a May 125 Call option. This means that the option will expire on the 3rd Friday in May. If the market price of IBM stock is above $125.00 on the close that Friday, then the option seller is obligated to deliver the stock to a holder of the option on Monday morning. The delivery of the stock is made at the strike price of $125.00 and that is the price that will be paid upon delivery of the stock.
This is the process, but in reality the broker in charge of the account will have made arrangements with the seller before the close on Friday to buy back (“buy to close”) the option before final expiration. But this is the process and should be understood by the seller to eliminate surprises.
Let’s assume for the following example that IBM
The math of this transaction looks like this
IBM’s Market Price = $128.00
Minus
The Call Strike Price = $125.00
Equals
Call’s Intrinsic Value per share = $3.00
The $3.00 intrinsic value of the option is of value to the owner. It is the value that is against the seller of the option.
For ever penny that IBM is above 125.00, the short option position is against the writer. Theoretically IBM could keep rising in price to infinity, and expose the short option position to unlimited risk.
What happens if IBM closed below $125.00 on the 3rd Friday in May?
It is assumed that IBM closed at $124.95 on Friday.
The math would look like this.
The Call Strike Price = $125.00
Minus
IBM’s Market Price = $124.95
Equals
Call’s Intrinsic Value per share = INITIAL_CONTENT.00
In this case the option has no value on expiration and the writer is under no obligation to deliver the stock.
Obviously there are ways to help minimize the risk of being an option writer. It is not the purpose of this article to discuss how to minimize risk, but rather to show the concept of option writing and to point out the risk at the extremes.
In later articles, the concept of writing an option against existing stock positions to create income will be discussed. Also how writing options in conjunction with the purchase of other options to create more elaborate strategies with defined risk will be explored.
John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool.