CandleFocus Glossary Editor
What is Overwriting?
Overwriting is a strategy used by investors to make extra income, especially from options written on dividend-paying stocks. Overwriting involves selling (writing) options that are overpriced compared to their true value, betting that the option won’t get exercised.
In general, writing options is a risky venture and should only be attempted by those investors with a comprehensive understanding of the options market and options strategies. This is because the investor is taking on the risk associated with the change in the price of the underlying asset, as well as any potential dividend they may have to pay out if the option is exercised.
When an investor writes an option, they are essentially accepting the obligation to buy (call option) or sell (put option) the security at the agreed-upon date at the agreed-upon price. This is known as being “long” the option. If the price of the security moves against the investor, he or she could potentially lose more than their original premium.
However, when an investor takes the approach of overwriting, they are betting that their options will not be exercised. This allows them to make a profit from the extra premiums they receive. This strategy can be profitable in situations where the price of the underlying asset is relatively stable, as the investor does not have to worry about a drastic change in the price adversely affecting their position.
An example of Overwriting
Suppose ABC Corporation trades at $50 per share, and pays a quarterly dividend of $1.00 per share. An investor is able to buy a call option at $10, with a strike price of $55 expiring in 6 months. The investor decides to write two call options at $12 each. This means the investor is effectively accepting an obligation to buy the shares in 6 months for $55 each if the share price is above that level.
At the end of the 6 months, the share price of ABC Corporation is $58. As the strike price on the call options is $55, they are “in-the-money” and therefore the investor has an obligation to buy the shares at the contracted price of $55. However, the investor will still make a profit from the $4 of difference between the share price and the strike price, and the additional $4 the investor received for writing the options, for a total of $8 per share.
The Bottom Line
Overwriting is a risky strategy, and can result in losses if the price of the underlying asset moves against the investor. Investors need to have a comprehensive understanding of the options market and options strategies in order to effectively use the overwriting technique and make a profit. However, if used correctly, overwriting can be a great way to make extra income.
Overwriting is a strategy used by investors to make extra income, especially from options written on dividend-paying stocks. Overwriting involves selling (writing) options that are overpriced compared to their true value, betting that the option won’t get exercised.
In general, writing options is a risky venture and should only be attempted by those investors with a comprehensive understanding of the options market and options strategies. This is because the investor is taking on the risk associated with the change in the price of the underlying asset, as well as any potential dividend they may have to pay out if the option is exercised.
When an investor writes an option, they are essentially accepting the obligation to buy (call option) or sell (put option) the security at the agreed-upon date at the agreed-upon price. This is known as being “long” the option. If the price of the security moves against the investor, he or she could potentially lose more than their original premium.
However, when an investor takes the approach of overwriting, they are betting that their options will not be exercised. This allows them to make a profit from the extra premiums they receive. This strategy can be profitable in situations where the price of the underlying asset is relatively stable, as the investor does not have to worry about a drastic change in the price adversely affecting their position.
An example of Overwriting
Suppose ABC Corporation trades at $50 per share, and pays a quarterly dividend of $1.00 per share. An investor is able to buy a call option at $10, with a strike price of $55 expiring in 6 months. The investor decides to write two call options at $12 each. This means the investor is effectively accepting an obligation to buy the shares in 6 months for $55 each if the share price is above that level.
At the end of the 6 months, the share price of ABC Corporation is $58. As the strike price on the call options is $55, they are “in-the-money” and therefore the investor has an obligation to buy the shares at the contracted price of $55. However, the investor will still make a profit from the $4 of difference between the share price and the strike price, and the additional $4 the investor received for writing the options, for a total of $8 per share.
The Bottom Line
Overwriting is a risky strategy, and can result in losses if the price of the underlying asset moves against the investor. Investors need to have a comprehensive understanding of the options market and options strategies in order to effectively use the overwriting technique and make a profit. However, if used correctly, overwriting can be a great way to make extra income.