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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Buy-Write

What it is:

A buy-write is an options strategy whereby an investor writes (sells) a call option at the same time he/she buys the underlying.

How it works (Example):

In a buy-write, which is very similar to a covered call, an investor sells a call option and buys the underlying simultaneously. The investor sells the call option at a strike price higher than the price paid for the underlying. The idea is that he will get to keep the proceeds from the sale of the option if the market price of the underlying does not rise above the strike price, but if the price of the underlying does rise above the strike price, most of the loss on the option is offset by the increase in the underlying's price.

Let's look at an example.

Assume Joe purchases 100 shares of XYZ stock for $1 per share. At the same time, he sells a call option for these hundred shares with a strike price of $2 per share. He sells the call option for $0.10 per share (the "premium"). If XYZ does not make it to $2, Joe gets to keep the $0.10. 

Let's assume that the price of XYZ does increase to $2.50 per share. Joe is now obliged to sell XYZ shares for $2 per share, and he takes a loss on the option of $2.00 - $2.50 = -$0.50 per share.

However, that $0.50 per share loss is offset by the $0.10 premium he already collected, plus the $1.50 increase in the price of the underlying. 

If Joe had not sold the call, he would get to keep the full $1.50 price increase that XYZ has experienced. By selling the call, he will only net $1.50 - $0.50 + $0.10 = $1.10.

To see different outcomes under other scenarios, see our definition for "covered call."

Why it Matters:

The safest way to sell an option is as part of a buy-write. The strategy is so safe, in fact, that it is suitable for most individual retirement (IRA) accounts. In this type of trade, the investor sells a call option on an underlying stock that he/she already owns. A call option written against stock you don't own is called a naked call

In the long run, because options tend to lose their value as they approach their expiration date, selling options tends to be much more profitable than buying options. In particular, the buy-write strategy works best when the investor plans on holding the underlying stock for a long period but does not expect a significant increase in the near term. The investor limits his/her upside potential in return for a guaranteed premium. [Click here to learn more about this strategy in the InvestingAnswers article, How to Generate an Additional Dividend Using Call Options.]

Buy-writes are most common among investors who want to generate additional income from a particular holding. Naked options, however, are mainly used for speculating. The investor must be very confident about the direction the stock will go and have the resources available to cover any mistakes. With buy-writes, the worst case is that the investor must sell the stock.

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