Overwriting is a trading strategy that involves selling options that are believed to be overpriced, with the assumption that the options won’t get exercised before they expire.
Key Takeaways
- Overwriting is a strategy to sell (write) options that are overpriced under the assumption that the options won’t get exercised.
- Overwriting is used to generate extra income, especially with options written on dividend-paying stocks.
- Overwriting is considered risky and should only be attempted by investors who have a comprehensive understanding of options and options strategies.
How Overwriting Works
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, hoping that they do not get assigned the short options. Investors may also refer to the strategy as “overriding.”
The writer (seller) of an option has an obligation to deliver their 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.
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 more than 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.
The downside risk to overwriting is that if the stock’s price rises sharply, the seller loses any profit they would have made above the options strike price. To combat this, the seller may want to buy the option back, although they would most likely need to repurchase it at a higher price than what they sold it for.
Overwriting Example
Suppose an investor holds a stock that is trading at $50. They decide to write a $60 call option against it that expires in three months and they receive a $5 premium. The buyer will likely exercise the 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—they get to keep the premium already collected AND continue 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.
Related Terms: Call Option, Dividend-Paying Stock, Options Premium, Strike Price.
References
Get ready to put your knowledge to the test with this intriguing quiz!
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## What is "overwriting" in financial market terminology?
- [ ] A technique for manual market prediction
- [ ] Synchronizing financial records
- [x] Writing covered call options to generate additional income
- [ ] Short selling securities to gain profit
## Which of the following best describes an objective of overwriting?
- [x] To generate additional income through premiums
- [ ] To minimize investment in safer assets
- [ ] To control national economic policies
- [ ] To track the performance of stocks
## In the context of overwriting, what is a "covered call"?
- [ ] A call option written without owning the underlying asset
- [ ] A call option that is written by a broker
- [x] A call option written against an asset that the investor already owns
- [ ] A call option that expires within a day
## What happens when a covered call option, related to overwriting, is exercised?
- [x] The underlying asset is sold at the strike price
- [ ] The investor receives back the option premium
- [ ] The investor buys more of the underlying asset
- [ ] The investor must short sell the underlying asset
## Which strategy can an investor use in conjunction with overwriting?
- [ ] Dollar-cost averaging
- [x] Buy-and-hold strategy with income enhancement through premiums
- [ ] Momentum investing to capture short-term gains
- [ ] Market timing to capitalize on fluctuations
## What risk does an investor face by overwriting call options?
- [ ] Unlimited losses if the option expires worthless
- [ ] Retaining the stock in all market conditions
- [ ] Margin calls from the broker
- [x] Missing out on large upside potential if stock prices rise significantly
## Which market condition is preferably advantageous for an overwriting strategy?
- [ ] High volatility environments
- [x] Low volatility environments with modest price growth
- [ ] Markets in rapid decline
- [ ] No specific market condition affects it
## What is a potential realized scenario for an overwritten call option when the stock stays below the strike price until expiration?
- [ ] The option is exercised, forcing the sale of stock above the market value
- [ ] The stock is liquidated automatically
- [x] The option expires worthless, and the investor keeps the premium received
- [ ] The ownership of stock is transferred to the option buyer
## Overwriting can best be used as a strategy for which kind of investor?
- [ ] A day trader seeking opportunistic profits
- [x] A conservative investor seeking incremental income
- [ ] An investor looking to heavily leverage positions
- [ ] A speculator wishing to exploit market inefficiencies
## What is one major consideration an investor must keep in mind when applying our overwriting strategy?
- [ ] Ensuring maximum capital appreciation
- [ ] Gaining maximum market exposure
- [x] Balancing the generation of income with the potential to lose upside price appreciation
- [ ] Speculating on high volatility plays
These quizzes should help in understanding the concept and implications of overwriting in financial terms.
