Writing options and overwriting are fundamental concepts in options trading. This entry delves into their distinctions, applications, and implications for traders and investors.
What Is Writing Options?
Writing options, or selling options, involves an investor granting the option’s buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before a specified date. The writer earns a premium for granting this right.
Types of Options Writing
There are two primary types of options writing:
- Covered Writing (Covered Call)
- The writer owns the underlying asset.
- Reduces risk compared to naked writing.
- Commonly used to generate additional income on a held position.
- Naked Writing (Naked Call or Put)
- The writer does not own the underlying asset.
- Higher risk as it may require buying the asset at a higher market price than the option’s strike price.
- Potential for substantial loss.
Example: Writing a Covered Call
An investor owns 100 shares of XYZ stock, currently trading at $50. They write a call option with a strike price of $55 expiring in one month for a premium of $2 per share. If the stock trades below $55 at expiration, they pocket the premium and retain the stock. If it rises above $55, the stock is sold at $55, plus any premium collected.
What Is Overwriting?
Overwriting refers specifically to the strategy of writing options on overpriced options, intending to capitalize on the inflated premium. This usually applies to covered calls but can refer to puts or other strategies.
Special Considerations for Overwriting
- Premiums and Volatility: Overwriting usually occurs when implied volatility is high, leading to higher option premiums.
- Income Generation: Aims to generate additional income from holding a security by consistently selling options that seem overpriced.
- Market Conditions: The strategy suits stable or slightly bullish market conditions to avoid losing the underlying asset.
Example: Overwriting Scenario
Assuming a stock with high implied volatility, priced at $60, and an investor believes the market has overestimated potential price swings. The investor writes a call option with a strike price of $65 for a substantial premium due to the high volatility. If the stock price remains below $65, the investor retains both the premium and the security.
Historical Context and Applicability
Historical Context
Options trading, tracing back to ancient Greece, has evolved significantly. Techniques like overwriting emerged with modern financial markets’ sophistication, allowing traders to deploy nuanced strategies.
Applicability in Modern Markets
- Risk Mitigation: Writing allows for premium collection as a hedge against price movements.
- Income Strategies: Overwriting suits investors seeking to maximize income from holdings, especially in volatile markets.
- Retail vs. Institutional: Commonplace among both individual investors and large institutions for strategic financial planning.
Comparisons
| Aspect | Writing | Overwriting |
|---|---|---|
| Definition | Selling options for a premium. | Targeting overpriced options for premium. |
| Risk Level | Varies (covered is lower risk; naked is higher) | Generally lower if underlying is stable; higher if not. |
| Applicability | Common across varied market conditions. | Best suited for volatile market conditions. |
Related Terms
- Call Option: Financial contract giving the buyer the right to buy an asset at a specific price.
- Put Option: Financial contract giving the buyer the right to sell an asset at a specific price.
- Implied Volatility: Market’s forecast of a likely movement in the asset’s price.
- Strike Price: The set price at which an option can be exercised.
- Premium: The price paid by the buyer to the writer for the option.
FAQs
What are the risks of writing options?
Why might an investor consider overwriting?
Can overwriting be applied to puts as well?
References
- Black, Fischer, and Myron Scholes. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 1973.
- CBOE (Chicago Board Options Exchange). “Options Trading and Strategies.”
- Hull, John C. “Options, Futures, and Other Derivatives.” Prentice Hall.
Summary
Writing and overwriting are crucial strategies in the realm of options trading, each serving distinct purposes and risk profiles. Writing options can form a fundamental part of risk management and income strategies, while overwriting enables investors to exploit market conditions for enhanced returns. By understanding the differences, investors can tailor their approaches to match market conditions and personal risk tolerance.
