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Selling to open is one of the possibilities available to options or derivatives traders. However, many investors might not be familiar with the concept though they can relate to buying to open, the standard entry point in options trading.
Selling to open refers to the opening of a short position in an options transaction.
A covered call is considered sell to open since you get a premium for selling off rights to the option. You benefit if the underlying asset doesn’t rise above your strike price. Likewise, with a covered call, you sell a call of a stock you own and collect a premium for the option.
In this article, you will find a detailed explanation of why a covered call is sold to open. Additionally, you will get answers to frequently asked questions regarding both covered calls and sell to open orders.
How A Covered Call Is A Sell To Open
Investors use sell to open orders when they are selling covered calls. As mentioned, sell to open is when an option trader initiates a trade either by selling or establishing a short position.
This allows the investor (the options seller) to receive the premium paid by the buyer. In addition, the action places the options seller in the short position on the call, whereas the buyer takes the long position on the security’s purchase.
The buyer expects the underlying asset to increase in value while the seller hopes it doesn’t go beyond the strike price – so they can retain the stock and benefit from the premium.
Now an investor can set up a sell to open position on a call option or put option depending on their preferred outlook. However, the sole aim is to collect a premium.
A call option is a contract that gives an investor (the buyer) the right to buy shares of an asset at an agreed-upon price by a particular future date.
If the trader already possesses the underlying security, then the call is said to be “covered” since they hold enough assets to cover the transaction. The opposite is a “naked position” whereby an investor doesn’t have the security to back up their sell to open trade.
Thus, a sell to open transaction comprises a covered call when the call’s short position gets initiated on a stock owned by the investor. Investors typically use the sell to open to generate premium income from a portfolio.
Here is an example to illustrate this:
An investor believing stock XYZ’s price will drop or stay the same in the next couple of weeks opens a sell to open position on the stock’s call options. Here, the seller speculates on XYZ’s price taking a downward shift orto stay stagnant, thus selling call options to another investor who bets that XYZ’s price will rise.
Therefore, by opening a short position, the seller becomes eligible to collect premiums on stock XYZ’s call options.
Are Covered Calls Really Profitable?
Covered calls can really be profitable for investors if a rise in the stock price does not go beyond the predetermined strike price of the sold call. However, every investment strategy carries a level of risk, and covered calls are no exception.
As such, covered calls may or may not turn a profit.
Thus, the investor gains from a slight increase in the stock’s value and receives a premium. Used correctly and with the right stock, a covered call can help you generate an income stream while reducing your overall costs.
But while covered calls might be a relatively low-risk means of generating an income from your stock positions, covered calls could limit further upside potential. This could happen if the stock were to continue soaring.
Also, covered calls wouldn’t offer much protection in case of a major drop in stock price.
Therefore, it’s essential to monitor your covered calls closely and be ready to take quick action in case of an unexpected sharp rally.
The primary goal of utilizing a covered call strategy, hence, is to earn premium income. Doing so can not only boost your portfolio returns but can also offer protection against downside movements.
Is A Covered Call Selling A Call?
A covered call is an investment strategy in which an investor is selling call options and owns a similar amount of the security underlying the option.
A covered call strategy is one where the person who owns stock sells a call against it. To execute a covered call, the investor holds a long position on an asset and sells (writes) call options to generate income in the form of premiums.
This investment strategy is suitable for investors intent on holding the underlying security for a long time while not expecting a notable price increase or decrease within the period. This essentially means that such an investor can generate premiums (income) while they wait for the expiration of the call.
The Difference Between Sell To Open and Sell To Close
The difference between sell to open and sell to close is seen when executing options trades. The term sell to open refers to the instance when an investor sells or writes a call or put option.
Sell to close implies that the investor is selling an option that they have purchased.
In the case of a regular call/put the buyer already possesses the options contract, selling the contract will result in closing the position so they will sell to close their position.
Selling to open is what someone does when they sell a covered call (or even sell a naked call) or a put. Since the trade is being opened then it is sell to open.
Sell to close is simply when an option buyer (put or call) sells their put or call back to the marker as they are selling their option to close their position.
In trading options, sell to open are orders used to sell covered calls. Selling to open means setting up a short position on a call option.
As an investor, you choose to sell to open based on the belief that the value of the security underlying the call option will decrease or increase slightly or remain the same.
And when you use a covered call strategy by selling options on shares you already own (or have recently acquired), you benefit from earning a premium income at no additional risk.