You did it!
You placed a new option position and you’re finally seeing some profit.
But before you break out the bubbly and party streamers, you need to first close the position and lock in that profit.
You fire up your brokerage account, switch over to the order page, and freeze...
Was the order you need sell to close? Buy to close? Or, maybe it was exercise the position?
When you first learn options, you always hear about exercising your options. After all, that is what strike price is all about. The strike price is our exercise price. However, in reality you will find that the exercise option is rarely used.
The confusing terminology of closing orders makes it difficult to decide which order to use at which time, especially in the heat of the moment. We will discuss when you should sell to close, buy to close, or exercise your option position. This will give you the best way to close your positions and lock in your profit.
When To Use Sell To Close
Your sell to close and buy to close orders are going to be used most frequently. The difference between the two depends on what position you have open.
When you open your position with a buy to open order, you use a sell to close order to close the position.
A buy to open order is used when you are buying your options, going long your position, or paying a net debit to open the position.
If you want to buy a long put on The Option Prophet (sym: TOP) you would use a buy to open order. This holds true for a long call, bull call spread, bear put spread, long straddle, long strangle, etc.
You believe that TOP will increase in price over the next month. To take advantage of this move, you buy to open 1 contract of TOP 40 Call for 2.00. TOP does increase, as you predicted, and now the call is worth 3.50. Your position is still 14 days out from expiration, but you want to go ahead and close the position, and lock in your profit. You use a sell to close order and collect $1.50 in profit.
3.50 – 2.00 = 1.50 profit
But what happens if you have a long option and a short option in one position? Option strategies such as bull call spreads and bear put spreads have both a long option and a short option in the trade.
The best way to keep track is to understand how you opened the overall trade. Bull call spreads and bear put spreads are both opened with buy to open orders. They are also opened with a net debit. Opening a position with a net debit means you are paying to open the position. Conversely, a net credit means you are receiving money to open the position.
So even though the position has a long and short option in it, because you opened it with a buy to open order, and because it is traded with a net debit, you would use a sell to close order to close the position.
A sell to close order can be used at any time during the life of the option. You do not have to wait until expiration before using it. If you want to open a position today, and use the sell to close order tomorrow, you can.
When To Use Buy To Close
If a sell to close order is used when you are net long on a position, or pay a net debit, then a buy to close order is used when you are net short on a position, or when you receive a net credit.
When you open your position with a sell to open order, you use a buy to close order to close the position.
If you want to short a call on The Option Prophet (sym: TOP) you would use a sell to open order. This goes the same for a short put, bull put spread, bear call spread, short straddle, short strangle, iron condor, etc.
You believe that The Option Prophet will increase in price over the next month. To take advantage of this move, you sell to open 1 contract of TOP 30 Puts for 1.25. TOP does increase, as you predicted, and now the put is worth 0.50. Your position is still 14 days out from expiration but you want to go ahead and close the position, and lock in your profit. You use a buy to close order and collect $0.75 in profit.
1.25 – 0.50 = 0.75 profit
Again, when you deal with an option strategy that has multiple long and short options in it, you need to think about the overall position. When you trade an iron condor, you are long two options and short two options. However, the total position is traded for a net credit. When you go to close the iron condor you will want to buy to close the position.
When Do You Exercise Your Options
If you buy to close after you sell to open and sell to close after you buy to open, when do you exercise your options?
Exercising an option is used when you want to convert your option position into stock. Most option traders never actually want to convert their options to stock, therefore, exercising options is rarely used.
There are times you may want to take possession of stock by converting your options. In order to exercise your options, you must be long a call or long a put.
Short options never have the ability to exercise their options, short options can only be assigned.
To go back to our option basics, a long call gives you the right to buy stock, and a long put gives you the right to sell stock.
You are long 1 contract of a TOP 40 call and TOP is trading for $45. You decide you want to take possession of the TOP stock so you exercise the contract. When you exercise the contract, you will purchase 100 shares of TOP at $40 (the strike price).
Now, when you purchase the stock, resist the urge to go back on the market and sell it for $45. If your intention is to simply purchase the stock and turn around and sell it for a profit, you don’t want to exercise. You can achieve the same results with less cost if you sell to close your position.
When we look at exercising a long put, you will sell the shares instead of buy the shares.
You are long 1 contract of a TOP 30 put and TOP is trading at $25. You decide you want to short the stock, so you exercise your contract. When you exercise the contract, you will short 100 shares of TOP at $30 (the strike price).
Just like with our long call, you don’t want to exercise the contract so you can immediately close the position and collect the profit. If that were the case, you would simply sell to close your long put. This will allow you to collect the profit with less overall cost.
If you want to exercise your option, you will need to contact your option brokerage and let them know of your intentions. Some brokerages will have buttons to designate that you want to exercise your option, but most brokerages will have you call in to confirm your intentions. Most brokerages are going to charge you an extra fee to exercise your options. You can quickly see and compare your brokerage fees at StockBrokers.com.
If your option is one-penny in-the-money at expiration, it will automatically be exercised by your brokerage. If you have no desire to exercise your option, you need to close it out with a buy to close or sell to close order before expiration. Waiting too long could be detrimental to your portfolio. You could go to sleep on Friday with 5 contracts that are slightly in-the-money and wake up Monday with 500 shares of stock in your portfolio.
Never Exercise An Option That Is Out-Of-The-Money
Never exercise an option that is out-of-the-money. Exercising options is meant for in-the-money options only. This is easily explained with an example.
You are long a call at the 50 strike. Your underlying is currently trading at $40, and you decide to exercise. Now you have converted your option into shares at $50.00 even though the underlying is only trading at $40; you have a loss. If you wanted to get the shares of the stock, you should have closed out your option, sell to Close, and bought the shares in the market for $40 instead of $50. Don't set yourself up by starting with a loss, only exercise in-the-money options.
Never Exercise An Option Before Expiration
By exercising your option before expiration you are forfeiting the properties of the option for which you’ve already paid.
First, you will forfeit the time value of the option. If your underlying is trading at $50, and your long a call option at the $45 strike, you will have at least a $5 profit (50 - 45). If you exercise your option before expiration, that is your only profit on that position.
If you have time remaining before expiration, your call will have a higher profit by itself. The profit on your call would be $5 + time value. As soon as you exercise, you lose the time value.
You could sell to close the option in the market for more than $5 if it is before expiration. The closer you get to expiration, the more your time value decreases until it reaches $0. At expiration your call would be worth $5 and that is when you exercise.
The second reason you don't exercise before expiration is because you will forfeit the insurance options provide.
You are long a call on the $30 strike that cost $3.00 and expires in two-weeks, and your underlying is trading for $40. You decide you’re close enough to expiration and want to exercise your call. You no longer have your option and now hold 100 shares at $30. The next day a surprise announcement is released that the company is under investigation for fraud. The stock begins to sink and at the end of the day is worth $20. You are now sitting on a $1,000 loss. If you would have held your option, it would be worthless now, but your total loss would have only been $300.
Even though you will start your option education learning about exercising options at the strike price, you will find that you rarely will exercise actual positions. Most option traders never want to take possession of the stock. They trade options to simply trade the contracts back and forth.
When you buy to open, go long, or pay a net debit for a position, you will use a sell to close to close the position.
If you sell to open, go short, or receive a net credit for a position, you will use a buy to close to close the position.
When you deal with a position that is more complicated, and has both long and short options, you will think back to how the original trade was set up. Did you go long the position and pay a debit, or did you go short the position and receive a credit.
If you do want to exercise your option, make sure your position is in-the-money and at expiration.
Never exercise a position to simply close out the trade and collect the profit. You will receive the same result for less cost if you use a buy to close or sell to close order.
When do you like to exercise your options? Tell us in the comments...