Of all the investment strategies available, plenty makes sense and some do not.
Writing a call option is one that doesn’t make much sense on the face of things. As this approach means the option writer is buying options from someone, who had previously purchased an option and is now looking to sell it before the options expiration date at the agreed strike price.
This is what makes it confusing, as most people would assume if there is an agreement to either purchase or sell something at a set price within a specified period or on a set date, we should follow through and complete the transaction.
Well, not in the world of options.
When it comes to options, there is no obligation to buy or sell anything. The contract gives you the right to buy or sell and that is it.
You can walk away from the contract if the terms of the contract are not met of if the contract expires.
It is a bit like having the first refusal at opportunities that comes your way. You have a look at what is happening and if it is going your way you hang around and if it is not you find a way to remove yourself from the situation.
This is what writing options is like.
What Does Writing A Call Option Mean?
A call option has been purchased and for whatever reason, the buyer of the option doesn’t want to hold onto it anymore. In comes the option writer who has a look and decides it would be a good fit and buys the call option from the owner.
The purchase of the call option by someone else is what is known as writing a call option.
There are two methods used to write options. These are covered options and naked options.
These methods determine who ends up with the underlying asset of the option.
Both call and put options can be written.
When writing a covered call option, i,e, buying call options, the underlying assets are held in the seller’s account, that is, the seller of the option.
If it is a covered put option, in other words, you are selling options the seller needs to ensure there is enough cash in the account to buy the required number of shares.
With this method of call writing, the writer does not own the underlying assets.
For this article, we’ll focus on writing covered call options only.
Writing A Call Option
Covered call option writing can be used to generate income for an equity portfolio and can also be used to set a price to sell the underlying equity.
As an example, an investor with 100 shares (one option) of a stock trading at $75 can write a covered call for a month with a strike price of $80.
A premium (price a call option writer pays) can be received by the investor. The investor can also sell the option if the share price is above the strike price at expiration as the underlying asset is still theirs.
The investor can in effect gets paid twice.
The option writer pays for the option and is betting on the direction the option would move in.
As the option is covered, the option writer does not have access to the underlying asset as it is still in the investor’s account.
The second way the investor makes money is by selling the underlying asset if its price is above the strike price at the expiration date.
If the price of the asset does not get up to $80 and the option expires, the owner of the option can repeat the process, that is sell the call option again, until the shares get called away, thereby generating more money.
This is one of the benefits of writing a covered call option, in that investors have two income streams operating simultaneously, and these streams can be repeated multiple times until the underlying asset is exercised.
Option Writing Is A Short Position
The option writer has a short window to hold the option, whereas the owner of the call option has a longer window to hold the option.
Hence why option writing is known as having a short position and the call option is known as having a long position.
Option Writing Concept
It is a simple enough concept to grasp, implementing, on the other hand, is more complex as there is a balance that needs to be achieved between writing an option and exercising a call option.
So now you know the basics of writing a call option. The process may take some getting used to at first, but you'll get the hang of it pretty soon.
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