Buy-Write (Options) - Explained
What are Buy-Write Options?
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Table of ContentsWhat are Buy-Write (Options)?How Does a Buy-Write Options Strategy Work?Implementing a Buy-Write TradeAcademic Research on Buy-Write (Options)
What are Buy-Write (Options)?
Buy-write is an options-based strategy in which an investor buys a stock, and at the same time, sells a call option on that very stock or asset. In this way, he/she can earn option premium, and hence, create income. Since the underlying position already provides a cushion to the options position, the risk of selling the option gets reduced. This strategy mirrors the strategy of writing or selling a covered call on the current position in the underlying asset. However, the timing of buy-write and writing a covered call varies.
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How Does a Buy-Write Options Strategy Work?
The buy-write strategy is based on the assumption that the market price of the underlying asset will not jump significantly from its existing price levels before it gets expired. This helps the investor (writing the call) in receiving premium by selling its options. It is important to keep the options strike price more than the price shelled out for the underlying asset. However, one must note that the more the strike price, the lesser amount of premium the investor will get. Another factor that results in higher premium is the timing until it expires. The more the time, the better the premium. But then the longer the wait for expiration period, lesser liquid the market will be, and the lesser will be the price. Hence, it gets too crucial to follow a balanced approach when dealing with strike price and expiration. If the price of underlying asset is more than the strike price, then the investor needs to exercise the option either at the time of or before the maturity date. This will lead to asset being sold at the strike price. He/she enjoys receiving premium indeed, however, they dont take advantage from excessive profits in the underlying price of the asset. The investor is of the belief that underlying price remains less in the short-run, and eventually gets higher in the long-run. Therefore, the investor gains by being patient for the increase in price in the long-run.
Implementing a Buy-Write Trade
Say, an investor finds XYZ stock as a reliable investment in the long-run. However, he/she is not completely confident about the time when the stock will be highly profitable. He/she plans to buy 100 shares in the stock market for $10 per share. The investor assumed that the price wont hit a rebound anytime soon, and thats why, he/she plans to exercise a call option for the same stock at a price of $12.50, therefore, offering it on sale for a premium amount of $2.5 per share. Till the time of maturity, if the price tends to be less than $12.50, the investor will retain the premium amount and the underlying stock. In case, the market price at the time of expiration period is $13 per share, he/she will not be able to secure the additional profit of $0.50 ($13 - $12.50). It will be interesting to note that this $0.50 amount is not the money that the investor didnt receive, but the money that he/she lost. When the investor plans to write a naked call, he/she will be required to approach the open market in order to buy shares to deliver. And the excessive amount of $0.50 per share will be considered as an actual capital loss.