What is Overwriting
Overwriting involves selling options that are believed to be overpriced or underpriced, with the assumption that the options won't get exercised. Overwriting is a speculative strategy that some option writers may employ to collect a premium even when they believe the underlying security is incorrectly valued. Investors may also refer to the strategy as "overriding."
BREAKING DOWN Overwriting
The writer/seller of an option has an obligation to deliver his shares to the buyer if the buyer decides to exercise the option, while the holder/buyer of an option has the right but not the obligation to purchase the seller's shares at a specific price within a specified time. Overwriting is a technique used by speculative option writers in an attempt to profit from the premiums paid by option buyers for option contracts the writer hopes will expire without being exercised. Overwriting is considered risky and should only be attempted by investors who have a comprehensive understanding of options and options strategies. (For further reading, see: The Ins and Outs of Selling Options.)
Why Overwriting is Used
Overwriting can help investors who hold a dividend-paying stock to increase their income by collecting the premium they receive from writing an option against the stock they own. For example, if they currently receive a 3% dividend yield, they could increase that yield to effectively over 10% by overwriting. The strategy is most effective when stock prices have had a sharp decline and premiums get overvalued, as the higher premiums help offset possible further losses. (To learn more about premiums, see: Getting a Handle on the Options Premium.)
Suppose an investor holds a stock that is trading at $50. He decides to write a $60 call option against it that expires in three months and he receives a $5 premium. The buyer will likely exercise his call option if the stock is trading above $60 before the expiry date, which limits the seller’s profit to $15 a share (the difference between $50 and $60, plus the $5 premium) on an asset that may continue to rise in value. This is why the seller hopes that the call option will expire worthless — he gets to keep the premium he has already collected AND he continues to hold an asset that is on the rise. If the stock declines, the $5 premium the seller received helps to partially offset any loss incurred.
The downside risk is that if the stock’s price rises sharply, the seller loses any profit he would have made above the options strike price. To combat this, the seller may want to buy the option back, although he would most likely need to repurchase it at a higher price than what he sold it for.