With the Options Clearing Corporation (OCC) guaranteeing every trade, you can freely enter and exit options positions. Understanding the four basic transaction types (and the three ways a position can end) is essential for options questions on the exam.
The Four Basic Transactions
| Transaction | Description | Effect on Position |
|---|---|---|
| Buy to open | Purchase an option to establish a new long position | Creates a new long position |
| Sell to open | Sell (write) an option to establish a new short position | Creates a new short position |
| Sell to close | Sell a previously purchased option to close the long position | Eliminates an existing long position |
| Buy to close | Buy back a previously written option to close the short position | Eliminates an existing short position |
Key distinctions:
- Opening transactions create new positions and increase open interest
- Closing transactions eliminate existing positions and decrease open interest
- An investor can close a position at any time before expiration by executing the opposite transaction
- Closing in the secondary market (selling to close or buying to close) is the most common way to exit an options position; most options are not exercised
Exam Tip: Gotchas
- "Sell to open" creates a new short position; "sell to close" eliminates an existing long position. The exam tests whether you know the difference.
- Most options are closed via offsetting transactions, not exercised.
Three Ways an Option Position Ends
Every option position must eventually end in one of three ways:
| Method | Who Initiates | Result |
|---|---|---|
| Closing transaction | Either buyer or seller | Position offset in the market; most common exit |
| Exercise / Assignment | Holder exercises; OCC assigns to writer | Physical delivery of stock (equity options) or cash settlement (index options) |
| Expiration | Automatic (no action needed) | Option expires worthless; holder loses full premium; writer keeps full premium |
- Closing transaction: The holder sells the option, or the writer buys it back. The position is eliminated.
- Exercise: The holder chooses to exercise the right. The OCC then assigns a writer. For equity options, actual shares change hands.
- Expiration: If the option is out of the money at expiration, it expires worthless with no action required. The holder loses the premium paid; the writer retains the premium collected.
Remember: Exercise is always the holder's choice. The writer can only be assigned (involuntarily) or can buy to close before that happens.
Exam Tip: Gotchas
- The writer can avoid assignment by buying to close before the holder exercises. Assignment is not inevitable.
- Exercise is always the holder's choice. The writer has no say in when (or whether) assignment happens.