What Does Buy-Write Mean?
Buy-write is an option trading strategy where an investor buys a security, usually a stock, with options available on it and simultaneously writes (sells) a call option on that security. The purpose is to generate income from option premiums. Because the option position only decreases in value if the price of the underlying security increases, the downside risk of writing the option is minimized. The most common example of this strategy is the use of a covered call on a stock already owned by an investor.
- Buy-write is an option strategy most often used on stocks.
- Selling a covered call is an example of a buy-write strategy.
- Buy-write strategies require a sound method for selecting the right strike price and expiration date to maximize gains.
- This strategy risk losing the position if the price of the underlying security rises too fast.
How the Buy-Write Strategy Works
This strategy assumes the market price for the underlying security will likely fluctuate only mildly and possibly rise somewhat from current levels before expiration. If the security declines in price or at least does not rise strongly, then the investor writing the call option gets to keep the premium received from the options sale. This strategy can be periodically repeated to increase returns during a time when the movement of the security is lackluster.
To execute this strategy well, the strike price of the option should be higher than the price paid for the underlying. This requires good judgement because the strike price needs to be higher than the likely degree of fluctuation, but not so high that the premium received is insignificant. Also, the longer the time until expiration, the higher the premium will be. However, the longer the term before expiration, the greater the chance that the security can rise too far. For the strategy to be successful investors must find a balance between expiration time and expectations of volatility.
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. This circumstance still results in profits, but usually it amounts to less profit than if the option strategy had not been used. So even thought the investor still keeps the premium received from the option, they no longer benefit from any additional gain in the underlying price. In other words, in exchange for the premium income, the investor caps his or 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.