What does 'Buy-Write' mean?

Buy-write is an options trading strategy where an investor buys an asset, usually a stock, and simultaneously writes (sells) a call option on that asset. The purpose is to generate income from option premiums. Because the options position is covered by the underlying position, the downside risk of writing the option is minimized.

It is very similar to writing a covered call on an existing position in the underlying asset. The only difference is the timing of the two trades.

BREAKING DOWN 'Buy-Write'

This strategy assumes the market price for the underlying will not rise significantly from current levels before expiration. If it does not, then the investor writing the call option gets to keep the premium received from the options sale.

The strike price of the option should be higher than the price paid for the underlying, but the higher the strike the further out of the money it will be, and the lower the premium received will be.

Also, the longer the time until expiration, the higher the premium will be. However, the farther the expiration, the more likely the market will lose liquidity, resulting in less efficient pricing. Therefore, investors must find the balance between strike price and expiration.

Should the underlying asset price rise above the strike price then the option will be exercised at maturity (or before) resulting in the investor selling the asset at the strike price. He/she still keeps the premium received but does not benefit from the additional gain in the underlying price. In other words, in exchange for the premium income, the investor caps his/her gain on the underlying.

Ideally, the investor believes that the underlying will not rally in the short-term but will be much higher in the long-term. He/she earns income on the asset while waiting for the eventual long-term rise in price.

Implementing a Buy-Write Trade

Suppose an investor believes that XYZ stock is a good long-term investment but is unsure of when its product or service will become truly profitable. He/she decides to buy a 100-share position in the stock at its market price of $10 per share. Because the investor does not expect the price to rally soon, he/she also decides to write a call option for XYZ stock at an exercise price of $12.50, selling it for a small premium.

As long as the price of XYZ stays below $12.50 until maturity, the trader will keep the premium and the underlying stock.

If the price rises above the $12.50 level and is exercised, the trader will be required to sell the shares at $12.50 to the option holder. The trade will only lose out on the difference between the exercise price and the market price.

If the market price at expiration is $13.00 per share, the investor loses out on the additional profit of $13.00 - $12.50 = $0.50 per share. Note that this is money not received, rather than money lost. If the investor simply writes an uncovered or naked call, he/she would have to go into the open market to buy the shares to deliver, and the $0.50 per share would become an actual capital loss.

RELATED TERMS
  1. Naked Call

    A naked call is an options strategy in which the investor writes ...
  2. Uncovered Option

    An uncovered option, or naked option, is an options position ...
  3. Option Premium

    1. The income received by an investor who sells or "writes" an ...
  4. Listed Option

    A listed option is a derivative security traded on a registered ...
  5. American Option

    An option that can be exercised anytime during its life. American ...
  6. Interest Rate Options

    An interest rate option is a financial derivative allowing the ...
Related Articles
  1. Trading

    The Basics of Covered Calls

    Learn how this options strategy can lower the risk of stock or futures contract ownership while increasing potential profits.
  2. Trading

    Getting acquainted with options trading

    Learn about trading stock options, including some basic options trading terminology.
  3. Retirement

    Write Covered Calls To Increase Your IRA Income

    Covered calls may require more attention than bonds or mutual funds, but the payoffs can be worth the trouble.
  4. Trading

    Three Ways to Profit Using Put Options

    A brief overview of how to profit from using put options in your portfolio.
  5. Trading

    Trading Options on Futures Contracts

    Futures contracts are available for all sorts of financial products, from equity indexes to precious metals. Trading options based on futures means buying call or put options based on the direction ...
  6. Investing

    Writing Covered Calls On Dividend Stocks

    Writing covered calls on stocks that pay above-average dividends is a strategy that can be used to boost returns on a portfolio, but it carries some risk.
  7. Trading

    Understanding The Options Premium

    The price of an option, otherwise known as the premium, has two basic components: intrinsic value and time value.
RELATED FAQS
  1. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  2. How Do Speculators Profit From Options?

    Options are a risky game, but you can learn speculators' tricks to use them to your advantage. Read Answer >>
  3. What is the difference between "right" and "obligation" on a call option?

    Learn what a call option is, what determines a buyer and seller of an option, and what the difference between a right and ... Read Answer >>
  4. When does one sell a put option, and when does one sell a call option?

    An investor would sell a put option if her outlook on the underlying was bullish, and would sell a call option if her outlook ... Read Answer >>
Hot Definitions
  1. Bond

    A bond is a fixed income investment in which an investor loans money to an entity (corporate or governmental) that borrows ...
  2. Compound Annual Growth Rate - CAGR

    The Compound Annual Growth Rate (CAGR) is the mean annual growth rate of an investment over a specified period of time longer ...
  3. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  4. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  5. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  6. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
Trading Center