Buy Write Options Explained

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Buy Write Options

An options trading strategy where an investor buys stock and sell call options against it is known as a buy write. Also known as covered write. To learn more about buy write, see covered call writing.

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Buy-Write

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.

Key Takeaways

  • 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.

The buy/write strategy: options basics

When using options it’s important to employ strategies wisely so you can maximize returns while limiting risk. Today, we’ll cover the buy/write strategy.

Last week, we looked at the fundamentals of using a covered call to increase return on investment . Before employing a buy/write strategy, you must understand how to write a covered call as the buy/write method is a specific covered call strategy.

While writing a covered call can be applied to multiple different scenarios, a buy/write play is very specific.

Essentially, a buy/write strategy is when a trader starts a position in a stock in increments of 100 shares -as you’ll recall, options are sold in lots of 100 shares-and instantly sells -or ‘writes’ in options speak-out-of-the-money or at-the-money options.

Before employing a buy/write strategy, traders should identify an equity with both of these attributes: high implied volatility and a stock with moderate-to-good prospects.

Traders tend to employ this strategy when a given stock’s options have high implied volatility. Otherwise, the potential opportunity cost outweighs the options premium derived from selling a call.

You also want to find a stock about which you feel moderately bullish. A buy/write strategy does not work particularly well when trying to bottom pick. Take for example, Research in Motion ( RIMM , quote ), which has had high implied volatility for the past few months. However, had you decided to try a buy-write strategy in this name six months ago, because the market has thumped RIMM , your initial principal would be roughly halved now.

This is why I prefer to employ a buy/write strategy with stocks about which I’m moderately bullish in the short-term, but that I don’t think will drop precipitously, or stocks that I’m comfortable owning down another 10% or 20%.

In the emerging world, one name that fits the bill is Melco Crown Entertainment ( MPEL , quote ). Although growth in Macao may be slowing, gaming revenues in the former Portuguese enclave are still strong. Although a stock with decent fundamentals , it tends to whipsaw, causing options for MPEL to be relatively expensive. At its closing price on Friday, $10.84, you can buy an 11 strike call for the month of August for $.65. This option offers roughly 6% downside protection and almost 8% profit if the stock is trading above $11.65 at expiration.

The point of such a trade is to make a relatively quick profit — 8% in a month and a half’s time — while also affording downside protection. Now, such a strategy can severely cap your profit potential, but in a volatile market like the one we’re in now, sometimes it behooves traders to try to hit singles instead of home runs.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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